2002 Annual Report - Novation Companies

Transcription

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OUTSTANDING
NovaStar Annual Repor t 2002
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The enthusiasm of youth, the wisdom of experience,
the gratifying growth of an enterprise we have nourished.
NovaStar, an outstanding financial ser vices company,
is as full of possibilities as the images in this repor t.
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Table of Contents
Who is NovaStar?
2
Letter to Shareholders
4
Business Over view
6
Selected Consolidated Financial and Other Data
17
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
18
Financial Statements
50
Independent Auditors’ Repor t
79
Corporate Information
80
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Earnings per Share
Common Dividends Declared
(Diluted Shares)
$4.50
$4.30
$3.02
$0.96
$0.50
$0.00
2000
2001
2002
2000
2001
2002
NovaStar Operational Facility
NovaStar Home Mor tgage Branches
NovaStar Headquar ters
Af filiated Branches
Loans Originated and Sold
Branches and Loan Volume
(Dollars in Millions)
Who is NovaStar?
$2,782
$2,623
NovaStar Financial, Inc., is one of the nation’s leading
We put in place long-term funding for our mor tgage
lenders and investors in nonconforming residential
lending by pooling loans as collateral for bonds and
SM
$1,560
216
$1,333
mortgage loans. Founded in 1996, NovaStar efficiently
selling a por tion of these securities to investors. In
brings together the capital markets and American
the process, NovaStar retains a high-return por tfolio
families financing their homes.
of securities backed by specified cash flows from
SM
$1,215
$1,088
$719
$584
123
63
these loans.
We focus on single-family, nonconforming mortgage loans,
$173
$193
2000
involving borrowers whose loan size, credit details or
We manage risk through carefully developed underwriting
other circumstances fall outside conventional agency
standards, mor tgage insurance, pooling and sale of
2001
2002
$142
$73
2000
2001
2002
Loans originated
#
Branches, end of year
63
mortgage loan guidelines. In a well-managed portfolio,
loans, and interest rate hedging strategies.
Loans sold in securitization
Loans Brokered
Loans sold to third par ties
these loans offer higher net interest margins than
NovaStar ser ves the nationwide market from our
conventional agency loans.
headquarters in Kansas City, Missouri. Our wholesale
NovaStar originates loans nationwide through NovaStar-
loan origination groups are based in Orange County,
affiliated mor tgage brokers, which we refer to as
California, and Cleveland, Ohio. Retail operations are
branches, independent brokers and direct contacts with
conducted from offices in Kansas City, Orange County
borrowers. We also provide servicing for loans we retain
and the Baltimore, Maryland, area. In 2002, we added
in our por tfolio, originate conforming mor tgage loans,
a processing center for conforming loans near Detroit,
and offer title and settlement services.
Michigan. Our title and settlement firm, AmPro Financial
Stockholders' Equity
Return on Equity
(Annualized)
$183
$130
30.30%
$108
27.04%
Ser vices, is based in Vienna, Virginia.
As a Real Estate Investment Trust (REIT), NovaStar
generates most of our earnings through mortgage securi-
Our common stock is traded on the New York Stock
ties held in portfolio.
Exchange under the symbol “NFI.”
2
5.50%
2000
2001
2002
2000
3
2001
2002
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To Our Shareholders:
NovaStar Financial thrived in 2002. Even as economic
•
and political uncertainties dampened some segments
We entered the retail lending business dealing directly
Looking forward, we expect continued strong growth in
with consumers from three new contact centers.
our business and earnings in 2003 as we expand our
of the world’s financial markets, we achieved record
branches, retail lending and wholesale sales force.
earnings and executed a successful growth strategy
NovaStar’s rapid growth in loan originations has been
amid favorable conditions for mortgage lending in the
driven, in part, by our emphasis on efficiency and cost
Of course, actual earnings and dividends will depend on
United States.
management. As a technology leader in the industry, we
future interest rates, loan production, volume of loans
provide a proprietary Internet-based system to a national
sold, market prices, availability of new capital and
Our 2002 per formance represented an encore of the
network of mortgage brokers and generate 99 percent
credit performance.
previous year’s profitable growth. Among the outstanding
of our nonconforming loan applications in an automated
achievements of NovaStar’s nationwide lending and
environment. In 2002, we launched our new NovaStarIS™,
NovaStar has been able to deliver stellar results
investment team:
giving mor tgage brokers the best Internet-based
because of an outstanding group of professionals who
under writing tool available today.
help our business succeed day after day. We want to
•
BOARD OF DIRECTORS
(FRONT ROW)
Scott Har tman
Chairman of the Board & Chief Executive Officer
Lance Anderson
President, Chief Operating Officer
Ar t Bur tscher
(BACK ROW)
Net earnings rose 51 percent to $48.8 million for
thank our over 2,200 associates, including 1,300
2002. Earnings per diluted share were $4.50, an
While benefiting from low interest rates and high
branch employees, as well as our many brokers and
increase of 49 percent from 2001. Annualized return
mortgage loan demand in 2002, our ongoing focus is on
other business partners, for all of the hard work and
on equity reached 30 percent.
building long-term value. We are positioning NovaStar to
caring collaboration in this exciting, fast-paced time.
We declared record dividends of $4.30 per common
through solid investment disciplines and strategic growth
We also want to thank you for your suppor t and
share, up from $0.96 per common share.
of our presence in the mortgage marketplace.
encouragement as a stockholder. We look forward
NovaStar originated $2.78 billion in loans, double
The NovaStar share price appreciated significantly in
our 2001 level, driving the growth of our securities
2002, although the stock was marked by volatility in an
por tfolio and related earnings. Our network of
uncertain investment market. Since NovaStar went public
branches brokered $2.62 billion in loans.
in November 1997, the stock has generated a total return
Greg Barmore
Chairman of the Compensation Committee
Edward Mehrer
Chairman of the Audit Committee
excel, even when the interest-rate environment changes,
•
•
•
to continuing to ser ve your interests in the future.
W. Lance Anderson
Scott F. Har tman
President and Founder
Chairman and Founder
to shareholders of nearly 130 percent (assuming dividends
We doubled the number of our branches and our
are reinvested), compared with a total return of negative
sales force. And we expanded our product line to
15 percent for the S&P 500 index. NovaStar shareholders
include origination of conforming loans, plus title
have earned a compounded annual total return averaging
and settlement services.
approximately 18 percent during this period.
4
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STRENGTH IN OUR NUMBERS
The financial results of NovaStar tell a stor y of
We also generate fee income through loan originations,
outstanding success. Net income has grown rapidly,
assistance to our branches, title and closing ser vices,
from $5.6 million in 2000 to $32.3 million in 2001
and ser vicing on loans originated through our network.
to $48.8 million in 2002. Annualized return on equity
These fee income ser vices generated 11 percent of
rose to a record 30.3 percent. Dividends of $4.30
net income in 2002.
per share based on 2002 earnings ranked NovaStar
We manage risk proactively at all stages through
among the highest-yielding U.S. stocks.
underwriting, insurance and hedging strategies. These
What gives strength to our numbers, though, is the
approaches substantially mitigate the near-term and
design of the business driving these results.
intermediate ef fects of interest rate volatility, credit
variations in our por tfolios, and market changes
NovaStar has created a power ful engine for originating
af fecting liquidity.
nonconforming mor tgage loans through one of the
nation’s leading networks of independent brokers,
In the long run, the strength of NovaStar will flow from
company-affiliated branches and three retail contact
our competitive position in the $150 billion market
centers. We raise long-term capital to fund the resulting
for nonconforming mor tgage loans. Our initiatives in
loans by selling securities backed by pools of loans.
creating a network of branches, offering cutting-edge
technology to help brokers originate loans, entering
Our business generates multiple earnings streams.
the retail origination business, and broadening our
In 2002, 89 percent of NovaStar’s net income came
product lines have substantially enhanced our position
from managing mor tgage por tfolios. In securitizing
in the industry.
loans, we retain securities backed by selected cash
flows, principally the spread between money-market rates
NovaStar’s financial flexibility is stronger than ever. With
and the interest rates on mortgages in the pools of loans
$1.3 billion in committed lending facilities and more than
we sell. Out of this spread we pay for interest rate
$80 million in cash and immediately available funds,
hedges and credit losses. These portfolios yield a high
we face the future with optimism and confidence. We
return on equity.
are on track for continued por tfolio and earnings growth
in 2003.
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GROWING OUR CORE BUSINESS
In 2002, we added substantial power to NovaStar’s
NovaStar also nearly doubled our branches, from 123 to
network for originating nonconforming mor tgages –
216 by year-end 2002. This network of brokers, launched
the growth engine for the loan por tfolio that drives
with a single office in 1999, has grown rapidly and is
our earnings.
contributing an expanding share of our portfolio. NovaStar
Two pipelines feed loans into NovaStar from outside:
brokers and operate under the name NovaStar Home
the wholesale channel of independent mor tgage brokers
Mortgage Inc., with our management guidance, leading-
and our growing team of branches. Suppor ting both
edge technology and administrative support.
branch managers are compensated as independent
groups are NovaStar’s wholesale sales force and
wholesale loan origination of fices.
Branches are free to broker loans to more than
250 mor tgage lenders – including NovaStar using
We made significant progress in building our wholesale
our under writing technology. Competing with lenders
organization in 2002:
nationwide to earn business, NovaStar won over
•
We originated $2.78 billion in loans, an increase
50 percent of the nonconforming loans originated
of 108 percent over 2001.
by our branches in 2002. Our branch business also
generates a revenue stream from fees on loans
•
The trade publication Origination News named
originated, including those funded by other lenders.
NovaStar the nation’s tenth largest subprime
wholesale volume lender for fourth quarter of 2002.
NovaStar branches represent an impor tant source of
growth, since our relationship enables us to gain a
•
We opened our second wholesale of fice in
much larger share of loans from branches than from
Cleveland, Ohio, to ser ve the Eastern United
independent brokers. We are actively recruiting for our
States. Our office in Orange County, California,
branch program and expect to add at least 200 more
ser ves the Western United States.
•
of fices in 2003. We also are working to enlarge the
share of the branches’ loans originated with NovaStar.
We doubled the number of wholesale account
executives, from 112 to 249, working with brokers
to generate loan production in 47 states.
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CREATING NEW OPPORTUNITIES
NovaStar is creating new products and approaches
Conforming loans. In September 2002, we broadened
to expand our market presence and add to our
our commitment to under writing conforming and
revenue streams. These initiatives suppor t our core
government loans, which fall within conventional
business of building our nonconforming loan por tfolio –
agency guidelines, opening a dedicated office in Troy,
and create oppor tunities for profitable growth in
Michigan. Our conforming product line strengthens
complementar y areas.
NovaStar’s appeal to mor tgage brokers and branches
who handle all kinds of loans, as well as creating a
The phenomenal growth of our branches, as well as
cost-ef ficient profit center for us.
relationships with some 3,500 independent brokers,
suggests a ready sales channel for new ser vices
Correspondent lending. We expanded our correspondent
related to our current business. We have taken action
program in 2002 to purchase more loans originated
in four areas:
by mor tgage bankers and other lenders, in line with
Retail loan origination. We entered the retail loan
team for correspondent relationships and began offering
origination market in 2002 by creating three borrower
these lenders the benefits of NovaStarIS under writing
contact centers, staf fed by loan of ficers, to work
technology and our full menu of products.
NovaStar under writing standards. We created a sales
directly with borrowers. The centers in the Baltimore
area, Kansas City and Orange County capitalize on
These initiatives represent milestones in NovaStar’s
the ef ficiencies of the Internet and our NovaStarIS
long-term strategy to expand our range of ser vices
technology to offer consumers the best loans available.
and strengthen relationships throughout the mor tgage
industr y. In addition to creating new profit oppor tunities,
Title and settlement services. In August 2002,
we expect the “one-stop shop” approach to fur ther
we established AmPro Financial Ser vices to provide
fuel the growth of NovaStar’s wholesale business in
fee-based closing services for NovaStar branches and
nonconforming loans.
brokers nationwide. Based in Vienna, Virginia, AmPro
offers NovaStar customers a “one-stop shop” that vastly
simplifies the title and closing process. AmPro represents
a new revenue stream and a marketing benefit.
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MAKING BUSINESS EVEN BETTER
By teaming the market’s most advanced technology
This new technology streamlines the automation
with NovaStar’s growing presence in the mor tgage
process and provides real benefits for NovaStar
industr y, the best got even better in 2002.
customers. For example, creating multiple loan
approval scenarios for each borrower means more
The launch of NovaStarIS, our second generation
oppor tunities to settle on the best loan saving the
Internet-based under writing tool, fur ther solidified
broker and borrower significant time and money.
our position as the industr y’s technological leader.
NovaStarIS dramatically simplifies and expedites the
Technological advances also are expanding NovaStar’s
under writing process for brokers and lenders. We have
relationships in the mortgage market. We are leveraging
put more distance between NovaStar and the competition
the power of NovaStarIS to suppor t our new retail
with this system’s speed, functionality and ease of use.
initiative and to offer correspondent lenders the benefits
of automated under writing, with streamlined loan
Three years ago, NovaStar introduced Internet
submissions and multiple approval scenarios.
Under writer, setting the standard for automated
under writing. Today, the new NovaStarIS has become
Technology, after all, is not about putting more bells
– hands down – the simplest and fastest Internet-
and whistles on a computer. It’s about making our
based under writing tool available to mor tgage brokers.
daily work go better. It’s about good ser vice. Good
products. Good business.
NovaStarIS of fers a three-step process for brokers:
First, obtain a credit repor t through NovaStar from
up to three repor ting ser vices; second, complete a
loan application and review multiple scenarios for
approvals based on NovaStar lending criteria; and,
third, close the loan.
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A PROMISING FUTURE
With a smooth-running infrastructure, the best technology
Analysts believe the overall mor tgage market may
and mor tgage ser vices available, and new initiatives
see originations flat to down in 2003, depending on
taking hold in key segments, we see a promising
economic factors and interest rates. We expect continued
future for NovaStar.
growth, however, for the approximately 10 percent of
2003 will be another year of strong growth, based on
Nonprime lending tends to be less sensitive to interest-
current run rates that we expect to continue through
rate fluctuations. Our goal for NovaStar is to outpace
the year. We continue to implement long-term strategies
the growth of the nonconforming market.
the industr y that represents nonconforming loans.
to grow NovaStar’s market share, and our investment
disciplines are targeting continued growth even in a
Additional revenue streams should continue to emerge.
changing economy.
We expect our branches and call centers to drive an
increase in conforming and government loan volume
During 2003, we expect to originate between
during 2003, leading to more fee income. AmPro is
$4 billion and $6 billion in nonconforming loans
expanding its presence in title and settlement ser vices.
through NovaStar’s wholesale, retail and correspondent
channels. We plan to open at least 200 new affiliated
With our financial strength, the industr y’s most
branches in 2003 and add account executives in
power ful technology tools and a strong team of
underser ved markets.
mor tgage professionals, we look for ward to creating
a bright future.
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N o v a S t a r F i n a n c i a l I n c . ANNUAL REPOR T 2 0 0 2
Selected Consolidated Financial and Other Data
(dollars in thousands, except per share amounts)
The following selected financial data are derived from our audited consolidated financial statements and should be read in connection
with the more detailed information therein and “Management’s Discussion and Analysis of Financial Condition and Results of
Operations” included in this annual report. Operating results are not necessarily indicative of future performance.
For the Year Ended December 31,
2001 (A)
2000
1999
2002 (A)
Consolidated Statement of Operations Data
Interest income
$ 107,143
Interest expense
38,596
Net interest income before provision for credit losses
68,547
Provision for credit losses
(432)
Gains (losses) on sales of mortgage assets
53,305
Losses on derivative instruments
(25,973)
General and administrative expenses
84,594
Equity in net income (loss) – NFI Holding
Income (loss) before cumulative effect of change in accounting principle
48,761
Cumulative effect of change in accounting principle (B)
Net income (loss)
48,761
Basic income (loss) per share
$
4.70
Diluted income (loss) per share
$
4.50
2002 (A)
Consolidated Balance Sheet Data
Mortgage Assets:
Mortgage loans
Mortgage securities
Total assets
Borrowings
Stockholders’ equity
$1,133,509
178,879
1,452,497
1,225,228
183,257
2002 (A)
Other Data
Loans originated, principal
Branches, end of year
Loans brokered through branches
Annualized return on assets
Annualized return on equity
Taxable income (loss)
Taxable income (loss) per share (C)
Dividends declared per common share (C)
Dividends declared per preferred share
Number of account executives
$2,781,539
216
$2,622,950
6.05%
30.30%
$
48,473
$
4.63
$
4.30
$
—
249
$
$
$
57,904
28,588
29,316
3,608
37,347
(2,731)
46,505
34,014
(1,706)
32,308
3.22
3.02
2001 (A)
$ 365,560
71,584
512,380
362,398
129,997
$ 47,627
34,696
12,931
5,449
(826)
$ 66,713
46,758
19,955
22,078
351
3,017
1,123
5,626
$
$
5,626
0.51
0.50
$
$
(7,092)
(1.08)
(1.08)
1999
$620,406
6,775
689,427
586,868
100,161
2001 (A)
2000
1999
$1,333,366
123
$1,087,971
6.03%
27.04%
$
5,242
$
0.91
$
0.96
$
1.08
112
$719,341
63
$193,191
0.97%
5.50%
$
(2)
$
—
$
—
$
0.49
85
$100,747
80,794
19,953
7,430
(14,962)
3,590
88
(7,092)
As of December 31,
2000
$375,927
46,650
494,482
382,437
107,919
1998
$452,554
1
$
—
(0.83)%
(6.71)%
$
(90)
$
(.01)
$
—
$
0.37
47
4,379
(2,984)
(21,821)
$
$
(21,821)
(2.71)
(2.71)
1998
$945,798
—
997,754
891,944
82,808
1998
$878,871
—
$
—
(1.66)%
(20.71)%
$ (2,628)
$
(0.32)
$
1.00
$
—
63
(A) Includes the assets, liabilities, equity and results of operations for NFI Holding Corporation. The common stock of NFI Holding Corporation was acquired on January 1, 2001.
Details of this transaction are discussed in Note 9 to our consolidated financial statements.
(B) Implementation of Statement of Financial Accounting Standards, No. 133 as discussed in Note 1 to our consolidated financial statements.
(C) On January 29, 2003, a $0.33 special dividend related to 2002 taxable income was declared per common share.
17
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Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated financial statements of NovaStar Financial and the notes
thereto included elsewhere in this report.
Safe Harbor Statement
“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar
Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties.
Certain matters discussed in this report may constitute forward-looking statements within the meaning of the federal securities laws
that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those
projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions,
fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the availability
of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors
outlined in the annual report on Form 10-K for the fiscal year ended December 31, 2002. Other factors not presently identified may
also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual
conditions experienced. It is not practicable to publish all revisions and, as a result, no one should assume that results projected in
or contemplated by the forward-looking statements will continue to be accurate in the future.
Description of Businesses
Mor t g a g e L e n d i n g a n d L o a n S e r vicing
• We operate as a long-term portfolio investor.
• Financing is provided by issuing asset-backed bonds and entering into reverse repurchase agreements.
• Earnings are generated from return on mortgage securities and spread income on the mortgage loan portfolio.
Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income was
$50.7 million, $46.2 million and $44.7 million in the three years ended December 31, 2002, 2001 and 2000, respectively. Net interest
income from the portfolio was $69.0 million, $25.7 million and $7.5 million in the three years ended December 31, 2002, 2001 and
2000, respectively. See our discussion of interest income under the heading “Results of Operations” and “Net Interest Income”.
A significant risk to our operations, relating to our portfolio management, is the risk that interest rates on our assets will not adjust at
the same times or amounts that rates on our liabilities adjust. Many of the loans in our portfolio, especially those that serve as collateral
for our mortgage securities, have relatively constant or fixed rates of interest. Our funding costs are generally not constant or fixed. We
use derivative instruments to mitigate the risk of our cost of funding increasing or decreasing at a faster rate than the change in interest
on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities).
In certain circumstances, because we enter into interest rate agreements which do not meet the hedging criteria set forth in generally
accepted accounting principles, we are required to record the change in the value of derivatives as a component of earnings even
though they may reduce our interest rate risk. In times where short-term rates drop significantly, as happened in 2002 and 2001,
the value of our agreements will decrease. As a result, we recognized losses on these derivatives of $26.0 million and $2.7 million in
2002 and 2001, respectively. However, the declining short-term funding rates cause the yields on our securities as well as the gains
we recognize on sales and securitizations of loans to increase.
Branches
• Retail mortgage brokers that broker loans for more than 200 investors, including NovaStar Mortgage, Inc.
• Branches operate under established policies.
• The net operating income for the branch is returned as compensation to the branch “owner/manager.”
The retail brokers provide an additional source for mortgage loan originations which, in most cases, we will eventually sell, either in
securitizations or in outright sales to third parties. During 2002, our branches brokered $2.6 billion in loans, of which $556 million
were funded by us.
Following is a diagram of the nonconforming industry in which we operate and our loan production during 2002 (in thousands).
The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage
securities that we hold in our portfolio. During 2002, we originated $2.8 billion in mortgage loans, the majority of which were retained
in our servicing portfolio and serve as collateral for our securities. Most of the loans we originate are sold, either in securitization
transactions or in outright sales to third parties. We recognized gains (losses) on sales of mortgage loans totaling $53.3 million, $37.3
million and $(826,000) during the three years ended December 31, 2002, 2001 and 2000, respectively. In securitization transactions,
we retain interest-only, prepayment penalty and subordinated securities, along with the right to service the loans.
Retail
NovaStar Direct to
Consumer
$224,445
Wholesale
A significant risk to our mortgage lending operations is liquidity risk – having financing facilities and cash available to fund and hold
loans prior to their sale or securitization. We maintain committed lending facilities with large banking institutions to reduce this risk.
Mor tgage Por t f o l i o M a n a g e m e n t
• We invest in assets generated primarily from our origination of nonconforming, single-family, residential mortgage loans.
18
Borrowers
NovaStar Branches
$2,422,590
Unrelated
Wholesale
Lenders
Unrelated Mortgage
Bankers/Financial
Institutions
$142,159
Whole Loans Sold or Delivered
to Unrelated Parties
$50,851
$375,645
Unrelated Broker
Securitization
$173,594
$2,066,950
Mortgage servicing yields fee income for us in the form of normal customer service and processing fees. We recognized $10.0 million,
$4.9 million and $1.6 million in loan servicing fee income from the securitization trusts during the three years ended December 31,
2002, 2001 and 2000, respectively.
Whole loan bulk purchases
$2,442,207
NovaStar
Wholesale
Lending
$1,560,001 (A)
NovaStar Acquisition of
Whole Loan Pools
$42,044
$–
(A) The portion of loans that NovaStar has not securitized as of December 31, 2002 is included in our mortgage loans held-for-sale.
19
NovaStar Securitization – $1,560,001
• We originate conforming and non-conforming residential mortgage loans.
• We reach the borrower through the retail mortgage broker and directly through outbound retail telemarketing.
• Non-conforming borrowers are generally individuals or families who do not qualify for agency/conventional lending programs because
of a lack of available documentation or previous credit difficulties.
• We acquire pools of mortgages from correspondents.
• We finance our loans through short-term warehouse facilities.
• Loans we originate are held for sale in either outright sales for cash or in securitization transactions.
• We service the loans we originate.
AAA-BBB rated Securities
Purchased by
Unrelated Bond Investors
$1,520,712
Excess Cash Flow and
Subordinated Bonds
(retained by NovaStar)
$90,785
Cumulative Loan Servicing
Portfolio Total
as of December 31, 2002
$3,657,640
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Significance of Estimates and Critical Accounting Policies
We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of
America and, therefore, are required to make estimates regarding the values of our assets and liabilities and in recording income and
expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we
believe are reasonable based on facts and circumstances existing at the time of reporting. The results of these estimates affect
reported amounts of assets, liabilities and accumulated other comprehensive income at the date of the consolidated financial statements
and the reported amounts of income, expenses and other comprehensive income during the periods presented. The following summarizes
the components of our consolidated financial statements where understanding accounting policies is critical to understanding and
evaluating our reported financial results, especially given the significant estimates used in applying the policies. The discussion is
intended to demonstrate the significance of estimates to our financial statements and the related accounting policies. Detailed accounting
policies are provided in Note 1 to our consolidated financial statements. Our critical accounting estimates impact only two of our three
reportable segments; our mortgage portfolio management and mortgage lending and loan servicing segments. Management has
discussed the development and selection of these critical accounting estimates with the audit committee of our board of directors
and the audit committee has reviewed our disclosure.
Mortgage Loans, Allowance for Credit Losses and Assets Acquired through Foreclosure Mortgage loans held-inportfolio are recorded at their cost, adjusted for the amortization of deferred costs and for credit losses inherent in the portfolio.
Mortgage loan origination fees and associated direct mortgage loan origination costs on mortgage loans held-in-portfolio are deferred and
recognized over the life of the loan as an adjustment to yield using the level yield method. An allowance for credit losses is maintained
for mortgage loans held-in-portfolio. Mortgage loans held-for-sale are recorded at the lower of cost or market. Mortgage loan origination
fees and direct mortgage loan origination costs on mortgage loans held-for-sale are deferred until the related loans are sold.
Assets acquired through foreclosure are carried at the lower-of-cost or estimated fair value less estimated selling costs. The carrying
value of the loan is adjusted at the time of foreclosure using a charge to the allowance for credit losses.
The allowance for credit losses on mortgage loans held-in-portfolio, and therefore the related charge to income, is based on the
assessment by management of various factors affecting our mortgage loan portfolio, including current economic conditions, the makeup
of the portfolio based on credit grade, loan-to-value, delinquency status, mortgage insurance we purchase and other relevant factors.
The allowance is maintained through ongoing provisions charged to operating income. The accounting estimate of the allowance for
credit losses is considered a “critical accounting estimate” as significant changes in the mortgage loan portfolio, our ability to obtain
mortgage insurance and/or economic conditions may affect the allowance for credit losses and net income. The assumptions used by
management regarding these key economic indicators are highly uncertain and involve a great deal of judgment. An internally developed
migration analysis is the primary tool used in analyzing our allowance for credit losses. This tool takes into consideration historical
information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date. We
also take into consideration our use of mortgage insurance as a method of managing credit risk. We pay mortgage insurance premiums
on loans maintained on our balance sheet and have included the cost of mortgage insurance in our income statement.
The allowance for credit losses was $3.0 million as of December 31, 2002 compared to $5.6 million at December 31, 2001. The
majority of the decline is due to the decline in our mortgage loans held-in-portfolio. Additionally, $400,000 was included in the
December 31, 2001 reserve balance for the expected loss on one loan. The loss on this loan was realized in June, and the reserve
was reduced by $400,000. The allowance for credit losses as a percent of mortgage loans held-in-portfolio was 2.0% and 2.5% as of
December 31, 2002 and 2001, respectively. No loans have been added to our portfolio since our last asset-backed bond transaction
treated as a financing transaction in 1998. If we were to assume the estimate of credit losses as a percent of outstanding principal
increased or decreased by 10%, the allowance for credit losses and related provision as of and for the twelve months ended December
31, 2002, respectively, would increase or decrease by $1.5 million. Mortgage insurance as a percentage of our mortgage loans
held-in-portfolio is 81.1% as of December 31, 2002 compared to 81.6% as of December 31, 2001. The make-up of our mortgage loan
20
portfolio is discussed under the heading “Mortgage Loans”. The allowance for credit losses is also discussed below under “Mortgage
Loans”. We discuss purchased mortgage insurance under the heading “Premiums for Mortgage Loan Insurance”.
Transfers of Assets (Loan and Mortgage Security Securitizations) and Related Gains In a loan securitization, we
combine the mortgage loans we originate in pools to serve as collateral for asset-backed bonds that are issued to the public. In a
mortgage security securitization (also known as a “Resecuritization”, see Note 1 in the consolidated financial statements), we combine
mortgage securities retained in previous loan securitization transactions to serve as collateral for asset-backed bonds that are issued to
the public. The loans or mortgage securities are transferred to a trust designed to serve only for the purpose of holding the collateral.
The trust is considered a qualifying special purpose entity as defined by SFAS No. 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125. The owners of the asset-backed bonds have no
recourse to us in the event the collateral does not perform as planned.
In order for us to determine proper accounting treatment for each securitization or resecuritizaion, we evaluate whether or not we have
retained or surrendered control over the transferred assets by reference to the conditions set forth in SFAS No. 140. All terms of these
transactions are evaluated against the conditions set forth in these statements. Some of the conditions that must be considered include:
• Have the transferred assets been isolated from the transferor?
• Does the transferee have the right to pledge or exchange the transferred assets?
• Is there a “call” agreement that requires the transferor to return specific assets?
• Is there an agreement that both obligates and entitles the transferor to repurchase or redeem the transferred assets prior to maturity?
Generally, we intend to structure our securitizations so that control over the collateral is transferred and the transfer is accounted for as
a sale. For resecuritizations, we intend to structure these transactions to be accounted for as secured borrowings.
When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is accounted for
as a sale. In accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial
assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at
the date of transfer. In a loan securitization, we do retain the right to service the underlying mortgage loans and we also retain certain
mortgage securities issued by the trust (see Mortgage Securities above). In a resecuritization, we retain an interest in a subordinated
security that represents the right to receive the cash flows on the underlying mortgage security collateral after the senior bonds have
been satisfied. As previously discussed, the gain recognized upon securitization (or resecuritization) depends on, among other things,
the estimated fair value of the components of the securitization (or resecuritization) – the loans or mortgage securities transferred, the
securities retained and the mortgage servicing rights. The estimated fair value of the securitization (or resecuritization) components
is considered a “critical accounting estimate” as 1) these gains or losses represent a significant portion of our operating results and
2) the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal
payments, prepayments and loan defaults are highly uncertain and require a large degree of judgment. The valuation of mortgage
securities is based on the present value of future expected cash flows to be received (See Mortgage Securities discussion above).
The rate used to discount the cash flow projections is critical in the evaluation of our mortgage securities. Management uses internal,
historical collateral performance data and published forward yield curves when modeling future expected cash flows.
For purposes of valuing our mortgage securities, it is also important to know that a significant portion of the underlying mortgage loan
collateral is covered by mortgage insurance. The cost of the insurance is paid by the trust from proceeds the trust receives from the
underlying collateral. The trust legally assumes the responsibility to pay the mortgage insurance premiums; therefore, we have no
obligation to pay these insurance premiums. We discuss mortgage insurance premiums under the heading “Premiums for Mortgage
Loan Insurance”.
The discount rates used in the initial valuation of mortgage securities for the twelve months ended December 31, 2002 compared with
same period of 2001 were 30% and 23%. The increase in discount rates in 2002 compared with 2001 was due to spreads widening
and returns on our securities increasing between the two periods. If the discount rate used in the initial valuation of our mortgage
21
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securities in 2002 had been increased by 500 basis points, the initial value of our mortgage securities would have decreased by $6.3
million and the gain recognized on the transfer of mortgage loans in securitizations would have decreased by $6.0 million. If we would
have decreased the discount rate used in the initial valuation of our mortgage securities by 500 basis points, the value of our mortgage
securities would have increased by $7.1 million and the gain recognized on the transfer of mortgage loans in securitizations would have
increased by $5.3 million.
Financial Condition as of December 31, 2002 and 2001
Mortgage Loans Our balance sheet consists primarily of mortgage loans we have originated. We classify our mortgage loans into
two categories: “held-for-sale” and “held-in-portfolio.” A portion of our loans serve as collateral for asset-backed bonds we have issued
and are classified as “held-in-portfolio.” The carrying value of “held-in-portfolio” mortgage loans as of December 31, 2002 was $150
million compared to $226 million as of December 31, 2001.
Information regarding the assumptions we used is discussed under “Mortgage Securities” in the following discussion.
When we do have the ability to exert control over the transferred collateral, the assets remain on our financial records and a liability is
recorded for the related asset-backed bonds.
Mortgage Securities Our mortgage securities represent beneficial interests we retain in securitization and resecuritization transactions.
The beneficial interests we retain in securitization transactions primarily consist of the right to receive the future cash flows from a pool
of securitized mortgage loans which include:
• The interest spread between the coupon on the underlying loans and the cost of financing.
• Prepayment penalties received from borrowers who payoff their loans early in their life.
• Overcollateralization, which is designed to protect the primary bondholder from credit loss on the underlying loans.
The beneficial interests we retain in resecuritization transactions represent the right to receive the remaining cash flows from the
underlying mortgage security collateral after the obligations to outside bondholders have been satisfied.
The cash flows we receive are highly dependent upon the interest rate environment. The cost of financing for the securitized loans is
indexed to short-term interest rates, while the loan coupons are less interest sensitive. As a result, as rates rise and fall, our cash
flows will fall and rise, which in turn will decrease or increase the value of our mortgage securities. Likewise, increasing or decreasing
cash flows will increase or decrease the yield on our securities. We adjust our yield (rate of income recognition) prospectively based on
the expectation for cash flows on the securities.
We believe the accounting estimates related to the valuation of our mortgage securities and establishing the rate of income recognition
on mortgage securities are “critical accounting estimates” because they can materially affect net income and require us to forecast
interest rates, mortgage principal payments, prepayments and loan default assumptions which are highly uncertain and require a large
degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our mortgage securities.
Management uses internal, historical collateral performance data and published forward yield curves when modeling future expected
cash flows and establishing the rate of income recognized on mortgage securities. We believe the value of our mortgage securities is
fair, but can provide no assurance that future prepayment and loss experience or changes in their required market discount rate will not
require write-downs of the residual assets. Write-downs would reduce income of future periods.
During 2002, we increased the accrual rates on our mortgage securities portfolio due to better cash flow performance as a result of the
widening spread between the coupon rates on the mortgage loan collateral and the floating rate bond liability rates. Our average security
yield has increased to 42.7% for the year ended December 31, 2002 from 17.3% for the same period of 2001. This resulted in a
corresponding increase in our mortgage securities income recognized during 2002. If the rates used to accrue income on our mortgage
securities during 2002 had been increased or decreased by 10%, net income during the twelve months ended 2002 would have
increased by $9.1 million and decreased by $5.8 million, respectively.
Loans we have originated, but have not yet sold or securitized, are classified as “held-for-sale.” We expect to sell these loans outright
in third party transactions or in securitization transactions that will be, for tax and accounting purposes, recorded as sales. We use
warehouse lines of credit and mortgage repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in mortgage
loans – held-for-sale and short-term borrowings between December 31, 2002 and December 31, 2001 is dependent on loans we
have originated during the period as well as loans we have sold outright or through securitization transactions. Details regarding loan
originations during 2002 as well as mortgage loans sold can be found in the “Mortgage Loan Production” and “Gains (Losses) on Sales
of Mortgage Assets and Losses on Derivative Instruments” sections of this document, respectively.
Premiums are paid on substantially all mortgage loans. Premiums on mortgage loans held-in-portfolio are amortized as a reduction
of interest income over the estimated lives of the loans. Table 5 provides information to analyze the impact of principal payments
on amortization. For mortgage loans held-for-sale, premiums are deferred until the related loans are sold. To mitigate the effect of
prepayments on interest income from mortgage loans, we generally strive to originate mortgage loans with prepayment penalties.
In periods of decreasing interest rates, borrowers are more likely to refinance their mortgages to obtain a better interest rate. Even
in rising rate environments, borrowers tend to repay their mortgage principal balances earlier than is required by the terms of their
mortgages. Non-conforming borrowers, as they update their credit rating, are more likely to refinance their mortgage loan to obtain
a lower interest rate.
Prepayment rates in Table 5 represent the annualized principal prepayment rate in the most recent three and twelve month periods and
over the life of the pool of loans. This information has not been presented for held-for-sale loans as we do not expect to own the loans
for a period long enough to experience material repayments.
Characteristics of the mortgage loans we own such as credit grade, coupon, loan-to-value, prepayment speeds and delinquency statistics
are provided in Tables 1 through 5. These characteristics are important as they provide key indicators of the credit and prepayment
risks inherent in our mortgage loan portfolio, which have a direct impact on our past and future operating performance. Note 2 to the
consolidated financial statements provides additional information regarding our mortgage loans. The operating performance of our
mortgage loan portfolio, including net interest income, allowance for credit losses and effects of hedging, are discussed under “Results
of Operations” and “Interest Rate/Market Risk.” Gains on the sales of mortgage loans, including impact of securitizations treated as
sales, is also discussed under “Results of Operations.”
As of December 31, 2002 and 2001, the weighted average discount rate used in valuing our mortgage securities was 25% and 27%,
respectively. The weighted-average constant prepayment rate used in valuing our mortgage securities as of December 31, 2002 was
40 versus 35 as of December 31, 2001. If the discount rate used in valuing our mortgage securities as of December 31, 2002 had
been increased by 500 basis points, the value of our mortgage securities would have decreased by $10.2 million. If we had decreased
the discount rate used in valuing our mortgage securities by 500 basis points, the value of our mortgage securities would have
increased by $11.7 million.
22
23
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Table 1 — Mortgage Loans by Credit Grade
Table 3 — Mortgage Credit Analysis – Held-in-Portfolio Loans
(dollars in thousands)
Allowed
Mortgage
Lates (A)
Credit
Grade
Maximum
Loan-to-value
December 31, 2002
December 31, 2001
Weighted
Average
Coupon
Weighted
Average
Coupon
Current
Principal
Weighted
Average
Loan-to-value
Current
Principal
Defaults as Percent of Current Principal
Weighted
Average
Loan-to-value
Original
Balance
Current
Principal
Weighted Average
delinquency
60-89
days
90 days and
greater
Foreclosure
and REO
Total
December 31, 2002
$1,115,760
$149,918
14.9%
1.9
2.0
7.9
11.8
December 31, 2001
$1,115,760
$226,960
11.5%
1.7
2.0
9.9
13.6
Held-in-portfolio:
AA
0 x 30
95
$ 22,770
9.33%
82.2%
A
1 x 30
90
59,773
9.67
79.8
$ 35,922
90,775
10.05
9.59%
79.1
82.1%
A-
2 x 30
90
34,933
10.18
81.6
53,971
10.52
81.5
B
3 x 30, 1x 60, 5 x 30, 2 x 60
85
20,163
10.60
77.7
28,400
11.05
77.4
C
1 x 90
75
10,216
11.21
71.9
15,122
11.53
72.3
D
6 x 30, 3 x 60, 2 x 90
65
2,063
11.20
65.1
2,770
12.15
64.8
$149,918
9.99%
79.5%
$226,960
10.34%
0 x 30
95
AAA
0 x 30
97(B)
$224,594
7.18%
3,476
11.99
76.3%
$ 11,662
Loans Repurchased From Trusts
Cumulative Losses as Reported,
as a Percent of Original Principal
Cumulative
Loss Amount
Loss as a % of
Original Principal
Total Losses
December 31, 2002
2.70%
$20,194
1.81%
4.51%
December 31, 2001
2.00%
$19,931
1.79%
3.79%
79.3%
Held-for-sale:
Alt A
Table 4 — Loss Analysis – Held-in-Portfolio Loans
8.74%
85.8%
37.2
28,892
8.70
74.5
78.9
AA
0 x 30
95
30,769
9.54
84.6
32,352
9.14
A+
0 x 30
95
350,558
7.84
77.8
—
—
—
A
1 x 30
90
127,514
8.48
81.3
25,218
9.21
79.1
A-
2 x 30
90
79,168
8.40
80.0
10,964
9.21
79.1
B
3 x 30, 1x 60, 5 x 30, 2 x 60
85
80,052
8.68
76.5
8,828
9.33
74.8
C
1 x 90
75
7,424
9.84
71.2
599
11.77
75.1
Other
Varies
97
68,805
8.33
85.9
19,559
9.33
86.1
8.00%
78.6%
9.08%
79.4%
Table 5 — Mortgage Loan Coupon and Prepayment Analysis
Original
Principal
Remaining
Prepayment Penalty
Period (in years) for
Loans with Penalty
Current
Principal
Premium
Percent with
Prepayment
Penalty
$149,918
$ 2,994
18%
9.99%
0.06
$972,360
$11,273
81%
8.00%
2.25
$226,960
$ 4,630
26%
10.34%
0.33
$138,074
$ 1,453
79%
9.08%
2.35
Coupon
Constant Prepayment Rate
(Annual Percent)
ThreeMonth
TwelveMonth
Life
32
34
33
As of December 31, 2002:
$972,360
$138,074
(A) Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category
would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
(B) 97% on fixed-rate only; all other maximum of 95%.
Held-in-portfolio (A)
$1,115,760
Held-for-sale
Not meaningful
Held-in-portfolio (A)
Table 2 — Mortgage Loans Geographic Concentration – Percent of Current Principal
Held-for-sale
December 31, 2002
Collateral Location
December 31, 2001
Held-in-portfolio
Held-for-sale
Held-in-portfolio
Held-for-sale
Florida
15%
14%
16%
11%
California
12
28
13
23
Texas
5
3
5
3
Indiana
5
2
5
2
Washington
5
2
6
1
Ohio
4
4
4
5
Michigan
3
4
3
7
51
43
48
48
100%
100%
100%
100%
All other states
Total
24
$1,115,760
33
38
32
Not meaningful
(A) Serving as collateral for NovaStar Home Equity Series asset backed bonds.
Mortgage Securities – Available-for-Sale Since 1998, we have pooled the majority of the loans we have originated to serve
as collateral for asset-backed bonds that are treated as sales for accounting and tax purposes. In these transactions, the loans are
removed from our balance sheet. However, we retained interest-only securities, which are AAA rated. We also retain the prepayment
penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations (see Mortgage Servicing
Rights under the header “Financial Condition as of December 31, 2002 and 2001). As of December 31, 2002 and 2001, the fair value
of mortgage securities was $178.9 million and $71.6 million, respectively. During 2002, we executed securitizations totaling $1,560
million in mortgage loans and retained mortgage securities with a value of $90.8 million.
During the period before loans are transferred in a securitization transaction, as discussed under “Net Interest Income”, “Interest
Rate/Market Risk” and “Hedging”, we enter into interest rate swap or cap agreements to reduce interest rate risk. We use interest rate
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cap and swap contracts to mitigate the risk of the cost of variable rate liabilities increasing at a faster rate than the earnings on assets
during a period of rising rates. In recent securitization transactions, we have not only transferred loans to the trust, but we have also
transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust. The trust assumes the
interest rate agreements and, therefore, the trust assumes the obligation to make payments and obtains the right to receive payments
under these agreements. Ultimately, the cash flows we receive on our interest-only securities are less volatile as interest rates change.
The value of our securities represents the present value of the securities’ cash flows that we expect to receive over their lives, considering
estimated prepayment speeds and credit losses of the underlying loans, discounted at an appropriate risk-adjusted market rate of return.
The cash flows are realized over the life of the loan collateral as cash distributions are received from the trust that owns the collateral.
In estimating the fair value of our mortgage securities, management must make assumptions regarding the future performance and
cash flow of the mortgage loans collateralizing the securities. These estimates are based on management’s judgments about the
nature of the loans. Table 6 summarizes our mortgage securities, the underlying collateral and the senior asset-backed bonds. Table 7
provides a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value
of the mortgage securities.
The performance of the loans serving as collateral for our mortgage securities is critical to the return our mortgage securities will
generate and their valuation. Credit quality and prepayment experience characteristics of the loan collateral, among others, are important
to properly analyze the performance of our mortgage securities. We have presented characteristics of the loans collateralizing our
mortgage securities in Tables 8 through 12.
Table 6 — Mortgage Securities
Asset-Backed Bonds
During the third quarter of 2001, we resecuritized AAA-rated interest-only and prepayment penalty securities issued in 2000. This
transaction, CAPS 2001-1, was structured as a sale for financial reporting and income tax purposes. In October 2002, the senior bond
was fully repaid and the AAA-rated interest-only and prepayment penalty securities were transferred back to us by the trust.
Weighted Average
Estimated
Fair Value of
Mortgage Securities
Remaining
Principal
Interest
Rate
Remaining
Principal
Coupon
Estimated
Months to Call
35,955
4.66%
9.85%
—
78,408
1.90
81,474
10.15
18
129,889
1.84
135,173
10.50
17
249,002
1.80
255,049
10.30
19
581,561
1.75
593,630
9.64
27
430,599
1.78
443,853
8.75
53
287,307
1.76
295,964
8.83
73
48,545
724,929
1.77
738,626
8.00
91
$178,879
$2,517,650
December 31, 2002:
NMFT 1999-1
Subordinated securities (non-investment grade)
$
4,250
$
$
42,724
NMFT 2000-1
Interest only (AAA-rated)
Prepayment penalty (AAA-rated)
4,073 (A)
643 (A)
1,340
6,056
NMFT 2000-2
6,686 (A)
999 (A)
2,421
10,106
The operating performance of our mortgage securities portfolio, including net interest income and effects of hedging are discussed
under “Results of Operations” and “Interest Rate/Market Risk.”
Mortgage Loans
NMFT 2001-1
12,029
2,117
2,210
16,356
NMFT 2001-2
During the fourth quarter of 2002, we resecuritized AAA-rated interest-only and prepayment penalty securities issued in 2001. This
transaction, CAPS 2002-1 was structured as a secured borrowing for financial reporting and income tax purposes. In accordance with
SFAS No. 140, control over the transferred assets was not surrendered, and thus the transaction was considered secured financing.
31,101
6,062
3,973
41,136
NMFT 2002-1
21,231
3,544
4,756
29,531
NMFT 2002-2
17,591
2,226
3,082
22,899
NMFT 2002-3
3,919
3,950
Total
26
40,676
27
$2,586,493
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Table 6 — Mortgage Securities
Table 7 — Characteristics of Loan Collateral, Valuation of Individual Mortgage
Securities and Assumptions
Asset-Backed Bonds
Mortgage Loans
Weighted Average
Estimated
Fair Value of
Mortgage Securities
Remaining
Principal
Interest
Rate
Remaining
Principal
Coupon
Estimated
Months to Call
December 31, 2002:
NovaStar Mortgage Funding Trust Series:
1999-1
2000-1
2000-2
2001-1
2001-2
2002-1
2002-2
2002-3
December 31, 2001:
Discount rate (%)
25
25
25
25
25
25
25
25
NMFT 1999-1
Constant prepayment rate (%)
38
53
57
59
53
38
29
24
$ 3,661
$
56,541
4.58%
$
62,665
10.23%
46
Total
As a percent of mortgage loan principal (%):
10.2
5.3
3.5
4.4
4.2
2.0
1.0
0.2
— (A)
Delinquent loans (30 days and greater)
Loans in foreclosure
5.5
5.0
2.9
2.7
1.8
1.1
1.0
0.2
— (A)
Real estate owned
5.5
4.5
2.4
2.4
1.5
0.2
0.1
—
Total losses
3.3
0.4
0.3
0.1
0.1
—
—
—
—
$ 984
$ 1,355
$ 1,766
$10,295
$14,925
$13,941
$31,729
—
273
379
311
2,007
2,491
1,764
3,057
10,282
5,791
299
792
324
1,315
3,343
2,443
3,081
17,388
4,500
7,580
13,955
27,519
8,772
4,751
10,678
76,214
$6,056
$10,106
$16,356
$41,136
$29,531
$22,899
$48,545
$178,879
NMFT 2000-1
560
560
145,538
2.18
149,400
10.16
44
Interest only (AAA- rated)
NMFT 2000-2
— (A)
— (A)
Cost basis of individual mortgage securities:
997
997
$
Prepayment penalty (AAA- rated)
252,995
2.18
259,037
10.59
41
Unrealized gain (loss)
(1,541)
Fair value (carrying value)
$4,250
$ 74,995
NMFT 2001-1
14,132
3,648
1,016
18,796
December 31, 2001:
NovaStar Mortgage Funding Trust Series:
367,468
2.28
373,949
10.35
50
NMFT 2001-2
31,428
6,130
1,813
39,371
772,296
2.09
784,617
9.70
61
CAPS 2001-C1
Total
2000-1
2000-2
2001-1
2001-2
CAPS
2002-C1
Discount rate (%)
25
40
40
25
25
40
Constant prepayment rate (%)
30
41
44
39
31
43
Total
As a percent of mortgage loan principal (%):
1999-1
Delinquent loans (30 days and greater)
8.8
3.7
1.9
2.2
—
(A)
Loans in foreclosure
6.0
2.8
2.6
1.1
—
(A)
Real estate owned
5.5
1.7
0.8
0.1
—
(A)
Total losses
1.8
0.1
—
—
—
(A)
—
$ —
$ —
$ 9,272
$26,783
—
—
—
3,325
4,640
—
7,965
5,366
413
661
619
421
3,094
10,574
Unrealized gain (loss)
(1,705)
147
336
5,580
7,527
5,105
16,990
Fair value (carrying value)
$3,661
$560
$997
$18,796
$39,371
$8,199
$71,584
Cost basis of individual mortgage securities:
8,199
19,241
$71,584
$1,614,079
7.25
(A)
$1,629,668
(A) Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment penalty mortgage securities of NMFT 2000-1 and 2000-2.
The AAA-IO and prepayment penalty mortgage securities were transferred back to us in October 2002 by the trust.
(A)
(A)
Interest only (AAA- rated)
Prepayment penalty (AAA- rated)
$
$
—
$36,055
The default and prepayment assumptions of the CAPS 2001-C1 bond are consistent with our valuation of the underlying mortgage loan
collateral of the securities sold in the CAPS 2001-C1 transaction. The discount rate reflects the uncertain nature of the cash flow on
the bond we retained.
28
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Table 8 — Loans Collateralizing Mortgage Securities by Credit Grade
Table 10 — Loans Collateralizing Mortgage Securities
Carrying Value of Loans by Product/Type
Credit
Grade
Alt A
AAA
Allowed
Mortgage
Lates (A)
Maximum
Loan-to-value
0 x 30
97(B)
0 x 30
97(B)
December 31, 2002
December 31, 2001
Current
Principal
Weighted
Average
Coupon
Current
Principal
Weighted
Average
Coupon
$ 246,980
7.87%
$—
—%
391,219
Weighted
Average
Loan-to-value
83.2%
8.65
80.6
319,360
Weighted
Average
Loan-to-value
9.64
—%
81.0
AA
0 x 30
95
547,795
9.34
82.4
482,718
10.17
A+
0 x 30
95
231,568
7.69
80.8
—
—
—
A
1 x 30
90
401,496
9.37
79.6
302,271
10.36
81.6
A-
2 x 30
90
205,000
9.45
78.6
190,054
10.52
81.0
B
3 x 30, 1x 60 5 x 30, 2 x 60
85
163,387
9.65
75.3
124,052
10.85
78.0
C
1 x 90
75
19,388
10.72
66.0
29,549
11.43
68.4
D
6 x 30, 3 x 60, 2 x 90
65
620
11.81
64.0
1,425
12.29
62.3
Varies
97
379,040
9.76
89.3
180,239
11.51
93.5
9.05%
81.8%
10.37%
82.9%
Other
83.9
December 31, 2002
December 31, 2001
$1,866,435
$1,236,328
Product/Type:
Two and three-year fixed
Six-month LIBOR and one-year CMT
1,167
2,607
718,891
390,733
Outstanding principal
$2,586,493
$1,629,668
Fair value of mortgage securities
$ 178,879
$
30/15-year fixed and balloon
Mortgage Loan Coupon and Prepayment Penalties
$2,586,493
$1,629,668
NovaStar
Mortgage Funding
Trust Series
(A) Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category
would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
(B) 97% on fixed-rate purchases; all other maximum of 95%.
71,584
Issue Date
Original
Principal
Current
Principal
Percent with
Prepayment
Penalty
Coupon
Remaining
Prepayment Penalty
Period (in years) for
Loans with Penalty
Constant Prepayment Rate
(Annual Percent)
ThreeMonth
TwelveMonth
Life
December 31, 2002:
Table 9 — Loans Collateralizing Mortgage Securities by Geographic Concentration
Percent of Current Principal
Collateral Location
December 31, 2002
December 31, 2001
California
19%
13%
Florida
1999-1
January 29, 1999
42,724
39
0.30
24
31
28
2000-1 (A)
March 31, 2000
$ 164,995
230,138
$
81,474
65
10.15
9.85%
0.98
40
45
30
2000-2 (A)
September 28, 2000
339,688
135,173
55
10.50
0.95
58
48
32
2001-1
March 31, 2001
415,067
255,049
75
10.30
1.02
36
31
23
2001-2
September 25, 2001
800,033
593,630
90
9.64
1.39
36
24
20
2002-1
March 28, 2002
499,998
443,853
88
8.75
1.88
19
—
13
2002-2
June 28, 2002
310,000
295,964
87
8.83
1.97
11
—
7
2002-3
September 27, 2002
750,003
738,626
82
8.00
2.05
—
—
—
$3,509,922
$2,586,493
82%
9.05%
1.64
$ 164,995
$
14
14
Michigan
6
9
Ohio
5
6
Nevada
4
5
Total
Arizona
4
5
December 31, 2001:
Tennessee
3
5
1999-1
January 29, 1999
62,665
42
10.23%
0.76
37
37
27
45
43
2000-1 (A)
March 31, 2000
230,138
149,400
88
10.16
1.65
35
30
21
100%
100%
2000-2 (A)
September 28, 2000
339,688
259,037
93
10.59
1.71
31
22
18
2001-1
March 31, 2001
415,067
373,949
89
10.35
2.02
18
—
11
2001-2
September 25, 2001
800,033
784,617
86
9.70
2.25
7
—
6
$1,949,921
$1,629,668
10.37%
2.00
All other states
Total
Total
87%
30
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Mortgage Credit Analysis
Defaults as Percent of Current Principal
Original
Balance
Current
Principal
Weighted Average
Loan-to-value Ratio
60-89
days
90 days
and greater
Foreclosure
and REO
Total
81.4%
2.0
1.6
10.8
14.4
December 31, 2002:
NMFT 1999-1
$ 164,995
$
42,724
NMFT 2000-1 (A)
230,138
81,474
81.3
1.9
0.7
8.8
11.4
NMFT 2000-2 (A)
339,688
135,173
83.7
1.5
1.0
8.7
11.2
NMFT 2001-1
415,067
255,049
83.8
1.4
1.1
6.9
9.4
NMFT 2001-2
800,033
593,630
82.8
1.0
0.5
3.6
5.1
NMFT 2002-1
499,998
443,853
81.3
0.5
0.2
1.5
2.2
NMFT 2002-2
310,000
295,964
81.0
0.5
0.1
1.0
1.6
NMFT 2002-3
750,003
738,626
80.6
0.1
0.1
0.1
0.3
$3,509,922
$2,586,493
$ 164,995
$
Total
81.8%
December 31, 2001:
NMFT 1999-1
81.8%
2.2
2.7
4.1
9.0
NMFT 2000-1 (A)
230,138
149,400
62,665
81.5
1.5
0.9
2.9
5.3
NMFT 2000-2 (A)
339,688
259,037
83.5
1.1
0.6
3.1
4.8
NMFT 2001-1
415,067
373,949
83.4
1.1
0.1
1.8
3.0
NMFT 2001-2
800,033
784,617
82.5
0.4
—
0.5
0.9
$1,949,921
$1,629,668
Total
82.9%
Other Assets Included in other assets as of December 31, 2002 is collateral required under the terms of our derivative instrument
contracts and other miscellaneous assets. Deposits with our derivative counterparties were $30.3 million as of December 31, 2002
compared with $18.0 million as of December 31, 2001. The value of the interest rate swaps offset the deposits by $18.2 million
and $9.8 million as of December 31, 2002 and 2001, respectively. These balances will generally decrease as interest rates rise and
increase when interest rates fall. Also included in other assets at December 31, 2002 and 2001 are fixed assets, net of accumulated
depreciation of $5.4 million and $1.3 million, respectively.
Asset-backed Bonds During 1997 and 1998, we completed the securitization of loans in transactions that were structured as
financing arrangements for accounting purposes. These non-recourse financing arrangements match the loans with the financing
arrangement for long periods of time, as compared to lines of credit and repurchase agreements that mature frequently with interest
rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of our asset-backed bonds we are entitled
to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance
falls below 35% of their original balance for the loans in NHES 97-01 and 25% for the loans in NHES 97-02, 98-01 and 98-02. We have
not exercised our right to repurchase any loans and repay bond obligations.
On November 5, 2002, we resecuritized AAA-rated interest-only and prepayment penalty securities and issued NovaStar CAPS Certificate
Series 2002-C1 in the amount of $68 million. The resecuritization was structured as a secured borrowing for financial reporting and
income tax purposes. In accordance with SFAS No. 140, control over the transferred assets was not surrendered and thus the transaction
was considered financing for the mortgage securities.
Details for all asset-backed bonds, and the related collateral that we have issued are in Note 5 to the consolidated financial statements.
Short-term Financing Arrangements Mortgage loan originations are funded with various financing facilities prior to securitization.
Loans originated are funded initially through one of three committed warehouse lines of credit. Repurchase agreements are used as
interim, short-term financing before loans are transferred in our securitization transactions. The balances outstanding under our shortterm arrangements fluctuate based on lending volume, cash flow from operating, investing and other financing activities and equity
transactions. Amounts outstanding and available for borrowing as of December 31, 2002 are listed in Table 13.
Table 13 — Short-term Financing Resources
Corporate Advances to Borrowers Advances on behalf of borrowers for taxes, insurance and other customer service functions
are made by NovaStar Mortgage, Inc. and aggregated $11.9 million as of December 31, 2002 compared with $6.9 million as of
December 31, 2001. These balances will generally increase as our assets and loan servicing balances increase.
(in thousands)
Mortgage Servicing Rights As discussed under Mortgage Securities – Available for Sale, we retain the right to service mortgage
loans we originate and have securitized. Servicing rights for loans we sell to third parties are not retained and we have not purchased
the right to service loans. As of December 31, 2002, we have $7.9 million in capitalized mortgage servicing rights compared with
$6.4 million as of December 31, 2001. The value of the mortgage servicing rights we retained in our securitizations during 2002 and
2001 was $6.1 million and $5.7 million, respectively. Amortization of mortgage servicing rights was $4.6 million and $2.1 million for
the years ended December 31, 2002 and 2001, respectively.
Credit Limit
Lending Value of Collateral
Borrowings
Lines of credit, mortgage and securities repurchase facilities
$1,375,000
$1,025,899
$1,025,536
363
Total
$1,375,000
$1,025,899
$1,025,536
$80,105
Unrestricted cash
$79,742
Other details regarding NovaStar Financial’s short-term borrowings are located in Note 5 to the consolidated financial statements.
Assets Acquired through Foreclosure As of December 31, 2002, we had 69 properties in real estate owned with a carrying
value of $5.9 million compared to 181 properties with a carrying value of $13.2 million as of December 31, 2001. The primary reason
for the decline in real estate owned between December 31, 2002 and 2001 are due to liquidations of properties during 2002. As the
loans in our portfolio mature and pay down, the total volume of loans decreases and the percentage of non-performing loans decreases
as the probability of default is higher in the early years of a loan’s life. Additionally, our mortgage insurance serves to mitigate our
exposure to loan losses (see Premiums for Mortgage Loan Insurance). Losses or gains from the ultimate disposition of real estate
owned are charged or credited to operating income and are detailed under the heading “Gains (Losses) on Sales of Mortgage Assets
and Derivative Losses”.
32
Availability
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Stockholders’ Equity The increase in our stockholders’ equity as of December 31, 2002 compared to December 31, 2001 is
primarily a result of the following:
•
•
•
•
•
•
•
•
Table 15 — Quarterly Mortgage Loan Originations by State
(based on original principal)
2002
$48.8 million increase due to net income recognized for the year ended December 31, 2002.
$55.6 million increase due to increase in unrealized gains on mortgage securities classified as available-for-sale.
$12.2 million decrease due to increase in unrealized losses on derivative instruments used in cash flow hedges.
$10.4 million increase due to net settlements on cash flow hedges reclassified to earnings.
$9.5 million decrease due to acquisition of warrants.
$1.8 million increase due to exercise of stock options.
$44.9 million decrease due to dividends on common stock.
$3.2 million increase due to compensation recognized under stock option plan.
Collateral Location
Fourth
2001
Third
Second
First
Fourth
Third
Second
First
California
29%
22%
22%
22%
22%
20%
18%
16%
Florida
14
14
12
12
12
12
16
13
Michigan
4
4
5
5
6
7
8
9
Ohio
4
4
5
4
5
4
5
6
Colorado
All other states
4
4
4
5
4
3
4
3
45
52
52
52
51
54
49
53
Mortgage Loan Production
Results of Operations
The volume and cost of our loan production is critical to our financial results. The loans we produce serve as collateral for our mortgage
securities and have generated gains as they are sold or securitized. The cost of our production is also critical to our financial results as
it is a significant factor in the gains we recognize.
During the year ended December 31, 2002, we earned net income of $48.8 million, $4.50 per diluted share, compared with net income of
$32.3 million, $3.02 per diluted share and of $5.6 million, $0.50 per diluted share, for the same periods of 2001 and 2000, respectively.
Our non-conforming loans are originated through a network of mortgage brokers throughout the United States. Approximately 3,500
brokers are active customers and approximately 10,800 are approved. Loans are underwritten and funded in a centralized facility. We
increased our sales force from 112 on January 1, 2002 to 249 on December 31, 2002. Our sales force operates in 47 states, which
allows us to mitigate the risk of geographical concentrations of credit risk.
Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fees from borrowers and gains on
the sales and securitizations of mortgage loans. Earnings increased during 2002 as compared to 2001 and 2000 due primarily to higher
volume of average mortgage securities held and increased accrual rates on our mortgage securities portfolio due to better cash flow
performance as a result of the widening spread between the coupon rates on the mortgage loan collateral and the floating rate bond
liability rates. The effect of the higher volume and increasing yield on our mortgage securities is displayed in Table 16.
The following tables summarize our loan production. The gains we have recognized are discussed under “Results of Operations”.
Additionally, we discuss our cost of production under “General and Administrative Expenses” under “Results of Operations”.
Net Interest Income
Table 14 — Non-conforming Loan Originations
(dollars in thousands, except for average loan balance)
Weighted Average
Number
Principal
Average
Loan Balance
Percent with
Prepayment
Penalty
Price Paid
to Broker
Loan to
Value
Credit
Rating (A)
101.3%
78%
5.68
7.6%
78%
Coupon
2002:
Fourth quarter
6,597
Third quarter
4,271
570,138
133,490
101.2
80
5.50
8.4
81
Second quarter
3,983
500,617
125,688
101.0
80
5.56
9.1
81
First quarter
3,602
471,994
131,037
101.0
80
5.45
9.0
84
18,453
$2,492,767
$135,087
101.1%
79%
5.57
8.3%
80%
Fourth quarter
2,944
$ 374,261
$127,127
101.0%
80%
5.45
9.3%
82%
Third quarter
3,179
370,349
116,499
101.0
81
5.43
10.0
81
Second quarter
2,930
344,892
117,710
101.0
81
5.38
10.0
82
First quarter
2,078
243,864
117,355
101.1
82
5.41
10.4
82
11,131
$1,333,366
$119,788
101.0%
81%
5.42
Total
$ 950,018
$144,008
The mortgage loans we originate and own have relatively high coupons and generally, in the aggregate, the coupon is not volatile. As a
result, the average yield on our loans has been fairly consistent. Rates on our financing arrangements adjust monthly, primarily indexed
to one-month LIBOR. As a result, the cost of financing increases and decreases with short-term market conditions. Short-term market
rates declined dramatically in 2001 and 2002 and, therefore, our net interest margin on loans increased dramatically. Interest income
on mortgage loans in the future will depend on the volume of loans we own. The net margin on our loans will depend on the coupons
on the loans and short-term borrowing rates, which are a function of market demand and economic conditions.
Our securities primarily represent our ownership in the net cash flows of underlying mortgage loan collateral in excess of bond expenses
and cost of funding. The cost of funding is indexed to one-month LIBOR. As one-month LIBOR decreased dramatically over the past two
years, the net cash flows we have received has increased correspondingly. Therefore, our yield (rate of accrual) on these securities has
increased. We experienced average income on our securities of 12.0% in 2000. The income increased to 17.3% and 42.7% in 2001
and 2002, respectively, to reflect the increase in cash flow. If rates continue to remain low, we anticipate the cash flow to continue to
be high on our securities and further increases in income may be generated. However, future interest income will be largely dependent
on economic conditions.
2001:
Total
(A) AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
34
9.9%
82%
Additionally, as discussed under Financial Condition – Mortgage Securities –Available-for-Sale, the trust that issues our interest-only
securities owns interest rate agreements. These agreements reduce interest rate risk within the trust and, as a result, the cash flows
we receive on our interest-only securities are less volatile as interest rates change. We also expect to increase the amount of mortgage
securities we own as we securitize the mortgage loans we originate.
Table 16 is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage
of the fair market value of these securities for the three years ended December 31, 2002. In Table 17, a summary of the net interest
income on our loans under management and the related yields for the three years ended December 31, 2002 is presented.
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Table 16 — Mortgage Securities Interest Analysis
December 31,
2002
Average fair market value on mortgage securities
2001
2000
$132,250
$67,588
$24,597
Average borrowings
89,612
37,004
8,993
Interest income
56,481
11,706
2,951
Interest expense
2,834
1,911
732
$ 53,647
$ 9,795
$ 2,219
Net interest income
Yields:
Interest income
42.7%
17.3%
12.0%
Interest expense
3.2
5.2
8.1
39.5%
12.1%
3.9%
40.6%
14.5%
9.0%
Net interest spread
Net Yield
All of NovaStar’s portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage securities).
Table 17 attempts to look through the balance sheet presentation of the Company’s portfolio income and present income as a percentage
of average assets under management. This metric allows the Company to be more easily compared to other finance companies or financial
institutions that use on balance sheet portfolio accounting, where return on assets is a common performance calculation.
The net income for mortgage loans held-in-portfolio and mortgage securities reflect the income after interest expense, hedging, servicing
and credit expense (mortgage insurance and provision to loss reserve).
Impact of Interest Rate Agreements We have executed interest rate agreements designed to mitigate exposure to interest
rate risk on short-term borrowings. Interest rate cap agreements require us to pay either a one-time “up front” premium or a quarterly
premium, while allowing us to receive a rate that adjusts with LIBOR when rates rise above a certain agreed-upon rate. Interest rate
swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements
are used to alter, in effect, the interest rates on funding costs to more closely match the yield on interest-earning assets. Due to the
steady decline in short-term interest rates in 2001 and 2002 and the increase in the average notional amount of interest rate swaps
outstanding, our expense related to interest rate agreements increased in these periods compared to 2000.
Provisions for Credit Losses
We originate and own loans in which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans
and losses are expected to occur. Provisions for credit losses are made in amounts considered necessary to maintain an allowance at
a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording
the value of real estate owned property at its estimated realizable value. One of the principal methods used to estimate expected losses
is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity
experience and applies that information to the portfolio at the reporting date.
We use several techniques to mitigate credit losses including pre-funding audits by quality control personnel and in-depth appraisal
reviews. Another loss mitigation technique allows a borrower to sell their property for less than the outstanding loan balance prior to
foreclosure in transactions known as short sales, when it is believed that the resulting loss is less than what would be realized through
foreclosure. Loans are charged off in full when the cost of pursuing foreclosure and liquidation exceed recorded balances. While short
sales have served to reduce the overall severity of losses incurred, they also accelerate the timing of losses. As discussed further
under the caption “Premiums for Mortgage Loan Insurance”, lender paid mortgage insurance is also used as a means of managing credit
risk exposure. Generally, the exposure to credit loss on insured loans is considered minimal. Management also believes aggressive
servicing is an important element to managing credit risk.
An increase in mortgage loan originations has lead to an increase in assets under management during the past two years. In addition,
during the past two years the interest rate environment has been very favorable for owning nonconforming mortgage loans and mortgage
securities. Table 17 shows the increase in both assets under management and the increase in the return on assets during the three
years ended December 31, 2002.
During the years ended December 31, 2002, 2001 and 2000 we made provisions for losses of ($0.4 million), $3.6 million and $5.4
million, respectively and incurred net charge-offs of $2.1 million, $5.7 million and $8.9 million, respectively. A rollforward of the allowance
for credit losses for the three years ended December 31, 2002 is presented in Note 2 to the consolidated financial statements.
Table 17 — Loans Under Management Net Interest Income Analysis
Fee Income
Fee income primarily consists of fees from four sources: broker fees, loan origination fees, service fee income and branch management fees.
Mortgage Loans
Held-in-Portfolio
Mortgage
Securities
Total
2002
Net interest income
$
Average balance of the underlying loans
$172,954
Net interest yield on assets
3,516
$
53,647
$2,080,955
2.03%
$
57,163
$2,253,909
2.58%
2.54%
2001
Net interest income
$
$266,287
3,446
$
9,795
$1,037,352
1.29%
$
1.02%
2000
Net interest income
$
$446,874
3,265
0.73%
36
$
2,219
$ 409,015
0.54%
$
Loan origination fees represent fees paid to us by borrowers and are associated with the origination of mortgage loans. Loan origination
fees are determined based on the type and amount of loans originated. Loan origination fees and direct origination costs on mortgage
loans held-in-portfolio are deferred and recognized over the life of the loan using the level yield method. Loan origination fees and direct
origination costs on mortgage loans held-for-sale are deferred and considered as part of the carrying value of the loan when sold.
13,241
$1,303,639
0.94%
Broker fees are paid by borrowers and other lenders for placing loans with third party investors (lenders) and are based on negotiated
rates with each lender to whom we broker loans. Revenue is recognized upon loan origination.
5,484
$ 855,889
Service fees are paid to us by either the investor on mortgage loans serviced or the borrower. Fees paid by investors on loans serviced
are determined as a percentage of the principal collected for the loans serviced and are recognized in the period in which payments on
the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include
late fees, processing fees and, for loans held in portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers
when an event occurs that generates the fee and they are considered to be collectible.
0.64%
37
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Affiliated branch management fees are charged to affiliated mor tgage brokers to manage their administrative operations, which include
providing accounting, payroll, human resources, loan investor management and license management. The amount of the fees is agreed
upon when entering a contractual agreement with affiliated mortgage brokers and are recognized as services are rendered.
Fee income increased from $20.2 million in 2001 to $33.8 million in 2002 due to the following reasons:
• Loans originated increased from $1.3 billion in 2001 to $2.8 billion in 2002.
• Our servicing portfolio increased from $2.0 billion in 2001 to $3.7 billion in 2002.
• The number of branches managed by us increased from 123 in 2001 to 216 in 2002.
We reported no fee income for 2000 due to the fact that all fee income is generated at NFI Holding Corporation and as discussed
previously, NFI Holding Corporation was not consolidated prior to 2001. As shown in Note 9 to the consolidated financial statements,
fee income would have been $9.9 million had NFI Holding been consolidated compared to $20.2 million in 2001. The increase is due
to the increase in our loan originations, servicing portfolio and the number of branches managed by us.
Gains (Losses) on Sales of Mortgage Assets and Losses on Derivative Instruments
We executed securitization transactions in which we transferred mortgage loan collateral to an independent trust. In those transactions,
we retained the AAA-rated interest-only and non-investment grade subordinated securities. In addition, we continue to service the loan
collateral. These transactions are structured as sales for accounting and income tax reporting. Whole loan sales have also been
executed whereby we sell loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights.
Table 19 provides a summary of mortgage loans sold outright and transferred in securitizations.
was applied prior to the adoption of SFAS No. 133 and since our interest rate agreements qualified for such, there were no gains or
losses on derivative instruments recorded in 2000.
Table 18 provides the components of our gains (losses) on sales of mortgage assets and losses on derivative instruments. Table 19 is
a presentation of our quarterly mortgage loan sales to third parties and the gain on sales of mortgage loans transferred in securitizations.
Table 18 — Gains (Losses) on Sales of Mortgage Assets
and Losses on Derivative Instruments
2002
Gains on sales of mortgage loans transferred in securitizations
2000
$47,894
$21,730
Gains on sales of mortgage loans to third parties – nonconforming
2,299
954
—
Gains on sales of mortgage loans to third parties – conforming
3,903
171
—
Gain on sale of mortgage securities
Losses on sales of real estate owned
Losses on derivatives
Total gains (losses) on sales of mortgage assets and losses on derivative instruments
For mortgage loans transferred in securitizations, we allocate our basis in the mortgage loans between the portion of the mortgage
loans sold and the retained assets, securities and servicing rights, based on the relative fair values of those portions at the time of
sale. The values of these servicing assets are determined by discounting estimated future cash flows using the cash flow method.
The weighted average assumptions used for the valuation of our retained assets at the time of securitization were a constant prepayment
rate of 27, projected losses of 1.3% and a discount rate of 24.7%.
During the third quarter of 2001, we resecuritized AAA-rated interest-only and prepayment penalty securities issued in 2000. This
transaction, CAPS 2001-1, was structured as a sale for financial reporting and income tax purposes. Senior bonds in the amount
of $29.3 million were sold to the public. We retained a subordinated interest, the CAPS 2001-1 C1 bond, and recognized a gain of
$14.9 million. For tax purposes, this gain was capital in nature and offsets existing capital losses we incurred in 1998. This transaction,
CAPS 2001-1, was structured as a sale for financial reporting and income tax purposes. In October 2002, the senior bond was fully
repaid and the AAA-rated interest-only and prepayment penalty securities were transferred back to us by the trust.
In 2000, we reported a loss of $0.8 million compared to gains of $37.3 million and $53.3 million on sales of mortgage assets in
2001 and 2002, respectively. Gains on securitizations and sales to third parties were recorded on NFI Holding Corporation’s financial
statements in 2000. As discussed previously, NFI Holding Corporation was not consolidated prior to 2001, but was accounted for using
the equity method. If NFI Holding had been consolidated in 2000, the gain on sales of mortgage assets would have been $14 million.
Much of the increase from 2000 to 2001 is related to the resecuritization (discussed previously) in which we recorded a $14.9 million
gain in 2001.
We have entered into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute
to our overall risk management strategy by serving to reduce interest rate risk related to short-term borrowing rates. Changes in the
fair value of these derivative instruments are credited or charged to current earnings. As interest rates decreased from December 31,
2001 to December 31, 2002, we recognized a loss of $26.0 million, reflective of the corresponding decrease in fair value of these nonhedge derivative instruments during 2002. Our loss on derivative instruments during 2001 was $2.7 million. As settlement accounting
38
2001
39
$
—
—
14,946
(791)
(454)
(826)
(826)
53,305
37,347
(25,973)
(2,731)
$27,332
$34,616
—
—
$(826)
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Table 19 — Quarterly Mortgage Loan Sales (A)
Prepayment Penalty Income
A large percentage of the loans we originate require the borrower to pay a cash penalty if they pay off their loan early in the loan’s
life, generally within two years of origination. This income serves to mitigate and offset prepayment risk and the amortization expense
of premiums we paid to loan brokers. The penalty is generally six months of interest on 80% of the unpaid principal at prepayment.
Prepayment penalty income was $432,000, $790,000 and $1.8 million during the years ended December 31, 2002, 2001 and 2000.
The decrease is due to the decline in the outstanding balance of loans held-in-portfolio and the expiration of prepayment penalties.
Outright Mortgage Loan Sales
Principal
Amount
Percent of
Total Sales
Net Gain (Loss) Weighted Average
Recognized
Price To Par
2002:
Fourth quarter
$
986
0.3%
$
64
102.5
(151)
100.2
Third quarter
13,727
3.3
Second quarter
80,421
16.2
1,332
103.0
First quarter
47,025
10.6
1,054
103.5
8.4%
$2,299
102.9
7.1%
Total
$142,159
2001:
$ 235
101.7
Third quarter
Fourth quarter
$ 25,524
19,511
4.0
84
102.0
Second quarter
17,516
7.9
373
102.3
First quarter
10,773
4.8
262
102.9
$ 954
102.1
Total
$ 73,324
5.7%
Mortgage Loans Transferred in Securitizations
Assumptions Underlying Initial Value
of Mortgage Securities
Principal
Amount
Percent of
Total Sales
Net Gain
Recognized
Initial Value
of Mortgage
Securities
Constant
Prepayment Rate
Discount
Rate
Expected Total Credit
Losses, Net of
Mortgage Insurance
Premiums for Mortgage Loan Insurance
The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage
insurance on loans maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income
statement under the caption “Premiums for Mortgage Loan Insurance” and totaled $2.3 million, $2.7 million and $1.3 million in 2002,
2001 and 2000, respectively. We received mortgage insurance proceeds of $2.1 million, $3.7 million and $3.0 million in 2002, 2001
and 2000, respectively.
It is important to note that substantially all of the mortgage loans that serve as collateral for our mortgage securities carry mortgage
insurance. This serves to reduce credit loss exposure in those mortgage pools. When loans are securitized in transactions treated as
sales, the obligation to pay mortgage insurance premiums is legally assumed by the trust. Therefore, we have no obligation to pay for
mortgage insurance premiums. Insurance premiums on these loans are paid from the collateral proceeds and, therefore, are not included
in the amount of total premiums for mortgage loan insurance expense in our statement of operations.
We intend to continue to purchase mortgage insurance coverage on the majority of newly originated loans as they are securitized.
However, we have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to
acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost
of coverage outweighs its benefit. We monitor the mortgage insurance market and currently anticipate being able to obtain affordable
coverage on a substantial portion of our future production.
General and Administrative Expenses
2002:
Fourth quarter
Third quarter
$ 346,043
403,960
99.7%
$12,461
$18,415
22
30%
1.00%
96.7
16,893
21,498
22
30
1.00
Second quarter
414,874
83.8
14,959
29,048
25
30
1.61
First quarter
395,124
89.4
3,581
23,942
28
30
1.65
Total
$1,560,001
91.6%
$47,894
$92,903
24
30%
1.33%
$ 334,501
92.9%
1.20%
2001:
$ 5,497
$15,784
28
25%
Third quarter
Fourth quarter
465,532
96.0
7,330
21,966
28
25
1.20
Second quarter
203,647
92.1
3,959
12,321
28
20
1.20
First quarter
211,420
95.2
4,944
12,791
28
20
1.20
$21,730
$62,862
28
23%
1.20%
Total
$1,215,100
94.3%
(A) Does not include conforming loan sales.
Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. Professional and outside
services include fees for legal and accounting services. In the normal course of business, fees are incurred for professional services
related to general corporate matters and specific transactions. Office administration includes items such as rent, depreciation, telephone,
office supplies, postage, delivery, maintenance and repairs.
The increase in general and administrative expenses from $46.5 million in 2001 to $84.6 million in 2002 is attributable to our new
conforming and retail lines of businesses, growth in our wholesale business including the opening of an office in Cleveland and our
expanding servicing operations. As a result of this growth, we employed 944 people as of December 31, 2002, compared with 379
and 284 as of December 31, 2001 and 2000, respectively. Total general and administrative expenses for 2000 were $3.0 million
compared to $46.5 million for 2001. This large increase is due to the fact that we did not consolidate NFI Holding prior to 2001.
If we had consolidated NFI Holding in 2000, total general and administrative expenses would have been $32.7 million. The increase
from 2000 to 2001 is due to an increase in compensation expense resulting primarily from the growth in our NovaStar Home Mortgage
branch operations. Note 12 to the consolidated financial statements presents a condensed income statement for our three segments,
detailing our expenses by segment.
The loan costs of production table below includes all costs paid and fees collected during the loan origination cycle, including loans that
do not fund. This distinction is important as we can only capitalize as deferred broker premium and costs, those costs (net of fees)
40
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directly associated with a “funded” loan. Costs associated with loans that do not fund are recognized immediately as a component of
general and administrative expenses. For loans held-for-sale, deferred net costs are recognized when the related loans are sold outright
or transferred in securitizations. For loans held-in-portfolio, deferred net costs are recognized over the life of the loan as a reduction to
interest income. Increased efficiencies in the non-conforming lending operation correlate to lower general and administrative costs and
higher interest income and gain on sales of mortgage assets.
We operate our mortgage brokerage unit under the name NovaStar Home Mortgage, Inc. (NHMI). Branch operations (offices) are divided
into two groups: 1) branches operating under NHMI, and 2) branches operating as separate companies with an administrative relationship
with NHMI, identified as NHMI LLC (Limited Liability Company) branches.
The NHMI branches are considered departmental functions of NHMI under which the branch manager (department head) is an employee
of NHMI and receives compensation based on the profitability of the branch (department) as bonus compensation. NHMI branches are
included in the NovaStar Financial consolidated financial statements.
Table 20 — Loan Costs of Production, as a Percent of Principal
Gross Loan
Production
Branches
Premium Paid to Broker,
Net of Fees Collected
Total
Acquisition Cost
2002:
Fourth quarter
1.74
0.92
2.66
Third quarter
2.03
0.86
2.89
Second quarter
2.13
0.58
2.71
First quarter
2.01
0.61
2.62
Fourth quarter
1.91
0.65
2.56
As of December 31, 2002 there were a total of 216 active branches, 9 of these were NHMI branches and 207 were NHMI LLC branches.
As of December 31, 2001 there were a total of 123 active branches, 15 of these were NHMI branches and 108 were NHMI LLC branches.
The NHMI and LLC branch offices offer conforming and non-conforming loans to potential borrowers. Loans are brokered for approved
investors, including NovaStar Mortgage, Inc. (NMI). Of the $2.8 billion and $1.3 billion loans we originated, 20% and 12% were brokered
to NMI from the branches in 2002 and 2001, respectively
2001:
Third quarter
1.92
0.56
2.48
Second quarter
1.86
0.61
2.47
First quarter
2.37
0.74
3.11
LLC branches are established through LLC agreements entered into between solicited brokers and NHMI. The LLC agreements provide
for initial capitalization and membership interests of 99.9% to the broker (branch manager) and .1% to NHMI. NHMI provides accounting,
payroll, human resources, loan investor management and license management in conjunction with separate contractual agreements.
We account for our minority interest in the LLC agreements using the equity method of accounting.
Table 22 — Loan Originations - Branches
Mortgage Loan Servicing
2002
2001
Loan servicing is a critical part of our business. In the opinion of management, maintaining contact with borrowers is vital in managing
credit risk and in borrower retention. Non-conforming borrowers are prone to late payments and are more likely to default on their
obligations than conventional borrowers. We strive to identify issues and trends with borrowers early and take quick action to address
such matters.
Amount
Loans brokered to NMI - non-conforming
$ 375,645
Loans brokered to NMI - conforming
Loans brokered to non-affiliates
Branch loan originations
Table 21 — Summary of Servicing Operations
%
14%
Amount
$ 119,573
%
11%
180,355
7
38,045
3
2,066,950
79
930,353
86
$2,622,950
100%
$1,087,971
100%
(dollars in thousands except per loan cost)
2002
Amount
2001
%
Amount
2000
%
Amount
Unpaid principal
$3,657,640
$1,994,448
$1,112,615
Number of loans
28,849
17,425
10,774
Servicing income, net of amortization of mortgage servicing rights
$
Costs of servicing
Net servicing income
Annualized costs of servicing per unit
$
2,478
0.27
1,560
0.31
1,473
0.53
2,181
0.24
1,303
0.26
1,185
0.43
$297
0.03
$257
0.05
$288
0.10
302.40
42
$
$
299.11
$
%
$
Income Taxes
NovaStar Financial, Inc. intends to operate and qualify as a Real Estate Investment Trust (REIT) under the requirements of the Internal
Revenue Code. Therefore, it will generally not be subject to federal income taxes at the corporate level on taxable income distributed to
stockholders. Requirements for qualification as a REIT include various restrictions on common stock ownership and the nature of the
assets and sources of income.
Following is a summary of the taxable net income available to common shareholders for the years ended December 31, 2002, 2001
and 2000.
439.95
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Table 23 — Taxable Net Income
2002
Consolidated net income
$48,761
Equity in net income of NFI Holding Corp.
2001
$32,308
9,013
REIT GAAP income
57,774
Adjustments to GAAP income
(9,301)
Taxable net income before preferred dividends
(1,723)
2000
$5,626
(1,123)
30,585
4,503
(20,179)
(2,954)
48,473
10,406
1,549
—
(5,164)
(1,551)
Preferred dividends
Taxable net income available to common shareholders
$48,473
$ 5,242
$
Taxable net income per common shareholder
$
$
$ (0.00)
4.63
0.91
(2)
NFI Holding Corporation, a wholly owned subsidiary of NovaStar Financial, Inc., has not elected REIT-status and files a consolidated
federal income tax return with its subsidiaries. NFI Holding Corporation reported a net loss before income taxes of $11.0 million for the
year ended December 31, 2002, which resulted in an income tax benefit of $2.0 million as shown in our statement of income. We did
not report income tax (expense) benefit for the years ended December 31, 2001 and 2000 due to the immaterial nature of the pre-tax
income reported at NFI Holding Corporation.
During the first quarter of 2002, we recognized a charge to taxable income of $3.7 million for the value of warrants converted by warrant
holders (see Note 8 to our consolidated financial statements). A charge of $9.5 million was recognized in the second quarter for the
warrants converted by RFC.
We are required to distribute only 90% of our taxable income to our stockholders. We declared dividends of $4.30 per common share in
2002. Since it was our intent to distribute approximately 100% of our taxable income in 2002, we declared a special dividend related
to 2002 taxable income of $0.33 per common share on January 29, 2003
Liquidity and Capital Resources
Liquidity means the need for, access to and uses of cash. Our primary needs for cash include the acquisition of mortgage loans, principal
repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating
activities of the business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected
on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements.
As shown in Table 13, we have $80.1 million in immediately available funds, including $79.7 million in cash.
Mortgage lending requires significant cash to fund loan originations. Our warehouse lending arrangements, including repurchase agreements,
support the mortgage lending operation. Our warehouse mortgage lenders allow us to borrow the greater of the market value of the
loans or 98% of the outstanding principal. Funding for the difference – generally 2% of the principal - must come from other cash
inflows. We use operating cash inflow in the form of cash flow from mortgage securities, principal and interest on mortgage loans and fee
income to support loan originations. In addition, proceeds from equity offerings have been used to support operations. Our immediately
available funds would support funding more than $4 billion in loans, assuming no other demands on cash and assuming a 2% “haircut”.
Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. The market
value of our loans are dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor
desire and capacity. Market values have been consistent over the past three years. However, there is no certainty that the prices will
44
remain constant. To the extent the value of the loans declines significantly, we would be required to repay portions of the amounts we
have borrowed. The value of our “recourse” loans (classified as held-for-sale) as of December 31, 2002 would need to decline by nearly
8% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.
We have no recourse for loans financed with asset-backed bonds and, as such, there is minimal liquidity risk.
The derivative financial instruments we use also subject us to “margin call” risk. Under our interest rate swaps, we pay a fixed rate to
the counterparties while they pay us a floating rate. While floating rates are low, on a net basis we are paying the counterparty. In order
to mitigate credit exposure to us, the counterparty required us to post margin deposits with them. As of December 31, 2002, we have
approximately $30.3 million on deposit. Further declining interest rates would subject us to additional exposure for cash margin calls.
However, the asset side of the balance sheet should increase in value in a further declining interest rate scenario. Incoming cash on
our mortgage loans and securities is a principal source of cash. The volume of cash depends on, among other things, interest rates.
While short-term interest rates (the basis for our funding costs) are low and the coupon rates on our loans are high, our net interest
margin (and therefore incoming cash flow) is high. Severe and immediate changes in interest rates will impact the volume of our incoming
cash flow. To the extent rates increase dramatically, our funding costs will increase quickly. While many of our loans are adjustable,
they typically will not reset as quickly as our funding costs. This circumstance would temporarily reduce incoming cash flow. As noted
above, derivative financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our interest
rate swaps and caps would provide additional cash flows to mitigate the lower cash on loans and securities.
Loans we originate can be sold to a third party, which also generates cash to fund on-going operations. When market prices exceed our
cost to originate, we believe we can operate in this manner, provided that the level of loan originations is at or near the capacity of its
production infrastructure.
Cash activity during the years ended December 31, 2002, 2001 and 2000 is presented in the consolidated statement of cash flows.
As noted above, proceeds from equity offerings have supported our operations. Since inception, we have raised $143 million in net
proceeds through private and public equity offerings. Equity offerings provide another avenue as a future liquidity source.
Off Balance Sheet Arrangements
As discussed previously, we pool the loans we originate and securitize them to obtain long-term financing for the assets. The loans are
transferred to a trust where they serve as collateral for asset-backed bonds, which the trust issues to the public. Our ability to use the
securitization capital market is critical to the operations of our business. Tables 6 and 7 summarize our off balance sheet securitizations.
External factors that are reasonably likely to affect our ability to continue to use this arrangement would be those factors that could
disrupt the securitization capital market. A disruption in the market could prevent us from being able to sell the securities at a favorable
price, or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall
of 1998, a terrorist attack, outbreak of war or other significant event risk, and market specific events such as a default of a comparable
type of securitization. If we were unable to access the securitization market, we may still be able to finance our mortgage operations
by selling our loans to investors in the whole loan market. We were able to do this following the liquidity crisis in 1998.
Specific items that may affect our ability to use the securitizations to finance our loans relate primarily to the performance of the loans
that have been securitized. Extremely poor loan performance may lead to poor bond performance and investor unwillingness to buy
bonds supported by our collateral. Our financial performance and condition has little impact on our ability to securitize, as evidenced
by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak.
We have commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans
to third parties. As commitments to originate, purchase and sell non-conforming loans are not readily convertible to cash and cannot
readily be settled net, these commitments do not meet the definition of a derivative under generally accepted accounting principles.
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Accordingly, they are not recorded in the consolidated financial statements. As of December 31, 2002, we had outstanding commitments
to originate, purchase and sell loans of $108 million, $16 million and $98 million, respectively.
Contractual Obligations
We have entered into certain long-term debt and lease agreements, which obligate us to make future payments to satisfy the related
contractual obligations. Notes 9 and 14 of the consolidated financial statements discuss these obligations in further detail.
The following table summarizes our contractual obligations with regard to our long-term debt and lease agreements as of December 31, 2002.
Table 24 — Contractual Obligations
Interest Rate Risk When interest rates on our assets do not adjust at the same rates as our liabilities or when the assets have
fixed rates and the liabilities are adjusting, future earnings potential is affected. We express this interest rate risk as the risk that the
market value of assets will increase or decrease at different rates than that of the liabilities. Expressed another way, this is the risk
that net asset value will experience an adverse change when interest rates change. We assess the risk based on the change in market
values given increases and decreases in interest rates. We also assess the risk based on the impact to net income in changing interest
rate environments.
Management primarily uses financing sources where the interest rate resets frequently. As of December 31, 2002, borrowings under
all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own, adjust on a monthly or
daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently
thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six
months thereafter.
Payments Due by Period
Contractual Obligations
Total
Less than 1 Year
1-3 Years
4-5 Years
After 5 Years
Long-term debt
$199,692
(A)
(A)
(A)
(A)
Operating leases (B) (C)
$ 13,163
$4,395
$4,599
$2,773
$1,396
(A) Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans which collateralize the debt.
The repayment of these mortgage loans is affected by prepayments.
(B) On August 12, 2002, we entered into a lease agreement for our new corporate headquarters in Kansas City, Missouri. Under this agreement,
the lessor agreed to repay us for certain existing lease obligations. We received approximately $62,000 related to this agreement in 2002 and expect
to receive approximately $2.3 million in future payments through 2007 from the lessor unless the properties we previously occupied are subleased..
(C) We entered into various sublease agreements for office space formerly occupied by us. We received approximately $704,000 in 2002 related
to these agreements and expect to receive approximately $501,000 in future payments through 2004.
While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if
short-term interest rates rise rapidly, earning potential is significantly affected, as the asset rate resets would lag the borrowing rate resets.
To assess interest sensitivity as an indication of exposure to interest rate risk, management relies on models of financial information in
a variety of interest rate scenarios. Using these models, the fair value and interest rate sensitivity of each financial instrument, or groups
of similar instruments is estimated, and then aggregated to form a comprehensive picture of the risk characteristics of the balance
sheet. The risks are analyzed on both an income and market value basis.
The following are summaries of the analysis.
Table 25 — Interest Rate Sensitivity-Income
Inflation
Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors drive company performance
far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates.
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and
dividends are based on taxable income. In each case, financial activities and balance sheet are measured with reference to historical
cost or fair market value without considering inflation.
(200) (C)
Basis Point Increase (Decrease) in Interest Rate (A)
(100)
Base
100
200
Interest margin
N/A
$168,379
$150,150
$130,828
$109,984
Expense from interest rate agreements
N/A
(42,284)
(32,949)
(20,573)
(6,060)
Net interest income
N/A
$126,095
$117,201
$110,255
$103,924
Impact of Recently Issued Accounting Pronouncements
Percent change in net interest income from base
N/A
7.6%
—
(5.9)%
(11.3)%
Note 1 of the consolidated financial statements describe certain recently issued accounting pronouncements. Management believes
the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a
material impact on the consolidated financial statements.
Percent change of capital (B)
N/A
4.9%
—
(3.8)%
(7.2)%
Interest Rate/Market Risk
Interest margin
N/A
$ 97,837
$ 83,300
$ 67,797
Expense from interest rate agreements
N/A
(21,647)
(14,636)
(7,624)
$ 55,007
Net interest income
N/A
$ 76,190
$ 68,664
$ 60,173
Percent change in net interest income from base
N/A
11.0%
—
(12.4)%
(20.8)%
Percent change of capital (B)
N/A
5.8%
—
(6.5)%
(11.0)%
(612)
$ 54,395
Our investment policy sets the following general goals:
(1) Maintain the net interest margin between assets and liabilities, and
(2) Diminish the effect of changes in interest rate levels on our market value
Loan Price Volatility Under our current mode of operation, we depend heavily on the market for wholesale non-conforming mortgage
loans. To conserve capital, we may sell loans we originate. Financial results will depend, in part, on the ability to find purchasers for
the loans at prices that cover origination expenses. Exposure to loan price volatility is reduced as we acquire and retain mortgage loans.
46
(A) Interest margin (income from assets less expense from liabilities) or expense from interest rate agreement in a parallel shift in the yield curve, up and down 1% and 2%.
(B) Total change in estimated spread income as a percent of total stockholders’ equity as of December 31, 2002 and 2001.
(C) A decrease in interest rates by 200 basis points (2%) would imply rates on liabilities at or below zero.
47
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• Loan-to-value ratios
• Prepayment penalties, if any
Table 26 — Interest Rate Sensitivity—Market Value
Basis Point Increase (Decrease) in Interest Rate (A)
(200) (C)
(100)
100
200
Change in market values of:
Assets
N/A
$ 16,449
Liabilities
N/A
(2,311)
$(49,343)
2,451
4,969
Interest rate agreements
N/A
(36,249)
37,930
76,873
Cumulative change in market value
N/A
$(22,111)
Percent change of market value portfolio equity (B)
N/A
10.9%
$ (8,962)
(4.4)%
$(119,232)
$ (37,390)
(18.4)%
Change in market values of:
Assets
N/A
$ 13,158
$(28,771)
Liabilities
N/A
(2,245)
2,382
6,414
Interest rate agreements
N/A
(15,505)
15,218
30,236
Cumulative change in market value
N/A
$ (4,592)
$(11,171)
Percent change of market value portfolio equity (B)
N/A
3.0%
(7.3)%
$ (67,162)
$ (30,512)
(19.8)%
Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest
rate a borrower currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline.
In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When a borrower has a low
loan-to-value ratio, he or she is more likely to do a “cash-out” refinance. Each of these factors increases the chance for higher prepayment
speeds during the term of the loan. On the other hand, prepayment penalties serve to mitigate the risk that loans will prepay because
the penalty is a deterrent to refinancing.
These factors are weighted based on management’s experience and an evaluation of the important trends observed in the non-conforming
mortgage origination industry. Actual results may differ from the estimates and assumptions used in the model and the projected
results as shown in the sensitivity analyses.
Projected prepayment rates in each interest rate scenario start at a prepayment speed less than 5% in month one and increase to a
long-term prepayment speed in nine to 18 months, to account for the seasoning of the loans. The long-term prepayment speed ranges
from 20% to 40% and depends on the characteristics of the loan which include type of product (ARM or fixed rate), note rate, credit
grade, loan to value, gross margin, weighted average maturity and lifetime and periodic caps and floors. This prepayment curve is also
multiplied by a factor of 60% on average for periods when a prepayment penalty is in effect on the loan. Prepayment assumptions
are also multiplied by a factor of greater than 100% during periods around rate resets and prepayment penalty expirations. These
assumptions change with levels of interest rates. The actual historical speeds experienced on our loans shown in Table 5 of
“Management’s Discussion and Analysis” are weighted average speeds of all loans in each deal.
(A) Change in market value of assets, liabilities or interest rate agreements in a parallel shift in the yield curve, up and down 1% and 2%.
(B) Total change in estimated market value as a percent of market value portfolio equity as of December 31, 2002 and 2001.
(C) A decrease in interest rates by 200 basis points (2%) would imply rates on liabilities at or below zero.
As discussed above, actual prepayment rates on loans that have been held in portfolio for shorter periods are slower than long term
prepayment rates used in the interest rate sensitivity analysis. Also, as pools of loans held in portfolio season, the actual prepayment
rates are more consistent with the long term prepayment rates used in the interest sensitivity analysis.
Interest Rate Sensitivity Analysis The values under the heading “Base” are management’s estimates of spread income for
assets, liabilities and interest rate agreements on December 31, 2002 and 2001. The values under the headings “100”, “200”, “(100)”
and “(200)” are management’s estimates of the income and change in market value of those same assets, liabilities and interest rate
agreements assuming that interest rates were 100 and 200 basis points, or 1 and 2 percent higher and lower. The cumulative change
in income or market value represents the change in income or market value of assets, net of the change in income or market value of
liabilities and interest rate agreements.
Hedging In order to address a mismatch of assets and liabilities, the hedging section of the investment policy is followed, as
approved by the Board. Specifically, the interest rate risk management program is formulated with the intent to offset the potential
adverse effects resulting from rate adjustment limitations on mortgage assets and the differences between interest rate adjustment
indices and interest rate adjustment periods of adjustable-rate mortgage loans and related borrowings.
The interest sensitivity analysis is prepared monthly. If the analysis demonstrates that a 100 basis point shift, up or down, in interest
rates would result in a 25% or more cumulative decrease in income from base, or a 10% cumulative decrease in market value from base,
policy requires management to adjust the portfolio by adding or removing interest rate cap or swap agreements. The Board of Directors
reviews and approves our interest rate sensitivity and hedged position quarterly. Although management also evaluates the portfolio
using interest rate increases and decreases less than and greater than one percent, management focuses on the one percent increase.
Assumptions Used in Interest Rate Sensitivity Analysis Management uses a variety of estimates and assumptions in
determining the income and market value of assets, liabilities and interest rate agreements. The estimates and assumptions have
a significant impact on the results of the interest rate sensitivity analysis, the results of which are shown as of December 31, 2002.
Management’s analysis for assessing interest rate sensitivity on its mortgage loans relies significantly on estimates for prepayment
speeds. A prepayment model has been internally developed based upon four main factors:
• Refinancing incentives (the interest rate of the mortgage compared with the current mortgage rates available to the borrower)
• Borrower credit grades
48
We use interest rate cap and swap contracts to mitigate the risk of the cost of variable rate liabilities increasing at a faster rate than
the earnings on assets during a period of rising rates. In this way, management intends generally to hedge as much of the interest rate
risk as determined to be in our best interest, given the cost of hedging transactions and the need to maintain REIT status.
We seek to build a balance sheet and undertake an interest rate risk management program that is likely, in management’s view, to
enable us to maintain an equity liquidation value sufficient to maintain operations given a variety of potentially adverse circumstances.
Accordingly, the hedging program addresses both income preservation, as discussed in the first part of this section, and capital
preservation concerns.
Interest rate cap agreements are legal contracts between us and a third party firm or “counter-party”. The counter-party agrees to make
payments to us in the future should the one- or three-month LIBOR interest rate rise above the strike rate specified in the contract. We
make either quarterly premium payments or have chosen to pay the premiums at the beginning to the counterparties under contract.
Each contract has a fixed notional face amount on which the interest is computed, and a set term to maturity. When the referenced
LIBOR interest rate rises above the contractual strike rate, we earn cap income. Payments on an annualized basis equal the contractual
notional face amount times the difference between actual LIBOR and the strike rate. Interest rate swaps have similar characteristics.
However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.
49
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Consolidated Balance Sheets
Consolidated Statements of Income
(dollars in thousands, except share amounts)
December 31,
2002
Assets
Cash and cash equivalents
$
79,742
$ 30,817
Mortgage loans – held-for-sale
983,633
139,527
Mortgage loans – held-in-portfolio
149,876
226,033
Mortgage securities - available-for-sale
178,879
71,584
11,875
6,893
Mortgage servicing rights
7,906
6,445
Accrued interest receivable
7,673
5,495
Corporate advances to borrowers
Assets acquired through foreclosure
Other assets
Total assets
5,935
13,185
26,978
12,401
$1,452,497
$512,380
$1,025,536
$143,350
Liabilities and Stockholders' Equity
Liabilities:
Short-term borrowings
Asset-backed bonds
199,692
219,048
Accounts payable and other liabilities
27,244
15,227
Dividends payable
16,768
4,758
1,269,240
382,383
Total liabilities
Commitments and contingencies
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000 shares authorized:
Class B, convertible preferred stock, 4,285,714 shares issued and outstanding
—
43
105
58
Additional paid-in capital
133,358
137,860
Accumulated deficit
(12,026)
Common stock, 10,479,910 and 5,804,255 shares issued and outstanding, respectively
(15,887)
Accumulated other comprehensive income
62,935
9,177
Notes receivable from founders
(1,115)
(1,254)
183,257
129,997
$1,452,497
$512,380
Total stockholders' equity
Total liabilities and stockholders' equity
See notes to consolidated financial statements.
2002
2001
Interest income:
Mortgage loans
Mortgage securities
$50,662
56,481
$46,198
11,706
$44,676
2,951
Total interest income
Interest expense
107,143
38,596
57,904
28,588
47,627
34,696
68,547
432
29,316
(3,608)
12,931
(5,449)
Net interest income
Fee income
Prepayment penalty income
Premiums for mortgage loan insurance
Other income, net
General and administrative expenses:
Compensation and benefits
Travel and public relations
Office administration
Loan expense
Professional and outside services
Other
68,979
53,305
33,830
432
(2,326)
(25,973)
3,077
25,708
37,347
20,204
790
(2,655)
(2,731)
1,856
7,482
(826)
—
1,776
(1,272)
—
360
49,060
11,400
10,092
8,002
3,402
2,638
26,934
7,008
6,394
1,865
1,989
2,315
1,485
—
751
—
690
91
Total general and administrative expenses
84,594
46,505
3,017
Income before income tax benefit, equity in earnings of unconsolidated subsidiary
and cumulative effect of a change in accounting principle
Income tax benefit
Equity in net income of NFI Holding Corporation
46,730
2,031
—
34,014
—
—
4,503
—
1,123
Income before cumulative effect of a change in accounting principle
Cumulative effect of a change in accounting principle
48,761
—
34,014
(1,706)
5,626
—
Net income
Dividends on preferred shares
48,761
—
32,308
(5,025)
5,626
(2,100)
2001
Net income available to common shareholders
$48,761
$27,283
$ 3,526
Basic earnings per share – before cumulative effect of a change in accounting principle
Basic loss per share due to cumulative effect of a change in accounting principle
$
4.70
—
$
3.38
(0.16)
$
0.51
—
Basic earnings per share
$
4.70
$
3.22
$
0.51
Diluted earnings per share – before cumulative effect of a change in accounting principle
Diluted loss per share due to cumulative effect of a change in accounting principle
$
4.50
—
$
3.18
(0.16)
$
0.50
—
Diluted earnings per share
$
4.50
$
3.02
$
0.50
Weighted average basic shares outstanding
10,379
10,025
11,137
Weighted average diluted shares outstanding
10,830
10,691
11,143
Dividends declared per common share
$
50
2000
51
4.30
$
0.96
$
—
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Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Convertible
Preferred
Stock
Balance, January 1, 2000
Additional
Paid-in
Capital
Common
Stock
$43
$ 75
$147,587
Common stock repurchased, 1,376,766 shares
—
(14)
Exercise of stock options, 10,000 shares
—
—
24
—
—
90
—
—
—
(5,704)
Accumulated
Other
Comprehensive
Notes
Total
Accumulated
Income
Receivable Stockholders’
Deficit
(Loss)
from Founders
Equity
$(41,502)
$
242
$(6,284)
—
—
—
—
—
—
—
—
(90)
—
—
$100,161
(5,718)
24
Change in fair value of restricted stock awards
underlying forgivable notes
Dividends on preferred stock ($0.49 per share)
(2,100)
—
(2,100)
Comprehensive income:
Net income
Other comprehensive income
5,626
—
5,626
—
9,926
9,926
Total comprehensive income
15,552
Balance, December 31, 2000
43
61
(37,976)
10,168
(6,374)
107,919
Common stock repurchased, 115,147 shares
—
(1)
(653)
—
—
—
(654)
(4,337)
—
—
4,340
—
—
—
—
139
139
141,997
Return of common stock underlying founders’ notes
receivable, 289,332 shares
—
(3)
—
—
Payment of founders’ notes receivable
—
—
—
—
—
641
641
—
1
853
—
—
—
854
Dividends on common stock ($0.96 per share)
—
—
—
(5,194)
—
—
(5,194)
Dividends on preferred stock ($1.08 per share)
—
—
—
(5,025)
—
—
(5,025)
Forgiveness of founders’ notes receivable
Net income
32,308
—
—
32,308
(991)
(991)
31,317
43
58
137,860
(15,887)
9,177
(1,254)
129,997
common, 4,285,714 shares
(43)
43
—
—
—
—
—
Acquisition of warrants, 812,731
—
—
(9,499)
—
—
—
(9,499)
Conversion of preferred stock to
Conversion of 350,000 warrants for
210,703 shares of common stock
Forgiveness of founders’ notes receivable
—
2
(2)
—
—
—
—
—
—
—
—
—
139
139
—
2
1,784
—
—
—
1,786
Compensation recognized under stock option plan
—
—
3,215
—
—
—
3,215
Dividends on common stock ($4.30 per share)
—
—
—
(44,900)
—
—
(44,900)
48,761
—
48,761
—
53,758
53,758
Cash flows from operating activities:
Net income
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Cumulative effect of change in accounting principle
Amortization of premiums on mortgage assets
Amortization of mortgage servicing rights
Accretion of available-for-sale securities
Amortization of deferred debt costs
Forgiveness of founders’ promissory notes
Proceeds from sale of mortgage loans held for sale
Originations of mortgage loans held for sale
Repayments of mortgage loans held for sale
Equity in net income of NFI Holding Corporation
Losses (gains) on sales of mortgage assets
Compensation recognized under stock option plan
Changes in:
Accrued interest receivable
Other assets
Other liabilities
Net cash provided by (used in) operating activities
Cash flows from investing activities:
Mortgage loan repayments—held-in-portfolio
Proceeds from paydowns on available-for-sale securities
Sales of available-for-sale securities
Sales of assets acquired through foreclosure
Net assets acquired in acquisition of common stock of NFI Holding Corporation
Payment on founders’ promissory notes
Net change in advances to and investment in NFI Holding Corporation
Net cash provided by investing activities
Cash flows from financing activities:
Payments on asset-backed bonds
Proceeds from asset-backed bonds
Change in short-term borrowings
Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs
Repurchase of warrants
Dividends paid on preferred stock
Dividends paid on common stock
Common stock repurchases
Net cash provided by (used in) financing activities
Net income
(in thousands)
102,519
—
$105
$133,358
$(12,026)
$62,935
$(1,115)
$183,257
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning of year
Cash and cash equivalents, end of year
52
53
2002
2001
$48,761
$32,308
2000
$5,626
—
1,930
4,609
(56,481)
172
139
(432)
1,930,059
(2,811,315)
10,943
—
(53,305)
25,973
3,215
1,706
3,208
2,131
(11,706)
1,022
139
3,608
1,302,856
(1,403,289)
1,731
—
(37,347)
2,731
—
—
4,944
—
(2,951)
1,141
—
5,449
—
—
—
(1,123)
826
—
—
(2,178)
(52,984)
(3,114)
3,817
(28,187)
1,325
3,301
(814)
1,869
(954,008)
(123,947)
18,268
65,505
100,497
—
14,876
—
—
—
125,198
40,190
28,626
20,466
872
641
—
201,880
6,604
—
35,263
—
—
(48,526)
180,878
215,993
195,221
(86,434)
66,906
882,186
1,786
(9,499)
(2,014)
(30,876)
—
(139,411)
—
81,450
854
—
(3,150)
(2,836)
(654)
(230,572)
—
25,000
24
—
(2,100)
—
(5,718)
822,055
(63,747)
(213,366)
48,925
30,817
28,299
2,518
123
2,395
$79,742
$30,817
$2,518
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Notes to Consolidated Financial Statements
December 31, 2002
Note 1.
S u m m a r y o f S i g n ificant Accounting and Repor ting Policies
Financial Statement Presentation The Company's consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America and prevailing practices within the financial services industry.
The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts
of assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the period.
The Company uses estimates and employs the judgments of management in determining the amount of its allowance for credit losses,
amortizing premiums or accreting discounts on its mortgage assets, amortizing mortgage servicing rights and establishing the fair value
of its mortgage securities, derivative instruments, mortgage servicing rights and estimating appropriate accrual rates on mortgage
securities. While the consolidated financial statements and footnotes reflect the best estimates and judgments of management at the
time, actual results could differ significantly from those estimates. For example, it is possible that credit losses or prepayments could
rise to levels that would adversely affect profitability if those levels were sustained for more than brief periods.
The consolidated financial statements of the Company include the accounts of all wholly owned subsidiaries. Significant intercompany
accounts and transactions have been eliminated during consolidation.
The Company purchased 100% of the common stock of NFI Holding Corporation on January 1, 2001 (See Note 9). Prior to this date,
the Company owned 100% of the nonvoting preferred stock of NFI Holding Corporation, for which it received 99% of any dividends paid by
NFI Holding Corporation. The founders of the Company owned 100% of the common stock of NFI Holding Corporation. The consolidated
financial statements as of December 31, 2002 and 2001 and for the years then ended include the accounts of NFI Holding Corporation
with significant intercompany accounts and transactions eliminated in consolidation. Prior to January 1, 2001, the Company accounted
for its investment in NFI Holding Corporation using the equity method.
Unconsolidated Affiliates The Company is party to limited liability company agreements (“LLCs”), formed to facilitate the operation
of retail mortgage broker businesses as branch affiliates. The LLC agreements provide for initial capitalization and membership interests
of 99.9% to a branch manager and .1% to the Company. The LLCs broker loans to mortgage investors, including a subsidiary of
the Company. The Company provides accounting, payroll, human resources, loan investor management and license management in
conjunction with separate contractual agreements. The Company accounts for its interest in the LLC agreements using the equity
method of accounting.
Cash and Cash Equivalents The Company considers investments with original maturities of three months or less at the date of
purchase to be cash equivalents.
Mortgage Loans Mortgage loans include loans originated by the Company and acquired in bulk pools from other originators and
securities dealers. Mortgage loans are recorded net of deferred loan origination fees and associated direct costs and are stated at
amortized cost. Mortgage loan origination fees and associated direct mortgage loan origination costs on mortgage loans held-in-portfolio
are deferred and recognized over the life of the loan as an adjustment to yield using the level yield method. Amortization includes the
effect of prepayments. Mortgage loans held-for-sale are carried at the lower of cost or market. Mortgage loan origination fees and
direct mortgage loan origination costs on mortgage loans held-for-sale are deferred until the related loans are sold.
Interest is recognized as revenue when earned according to the terms of the mortgage loans and when, in the opinion of management,
it is collectible. The accrual of interest on loans is discontinued when, in management's opinion, the interest is not collectible in the
normal course of business, but in no case beyond when a loan becomes ninety days delinquent. Interest collected on non-accrual loans
is recognized as income upon receipt.
54
The mortgage loan portfolio is collectively evaluated for impairment as the loans are smaller-balance and are homogeneous in nature.
The Company maintains an allowance for credit losses inherent in the portfolio at the balance sheet date. The allowance is based upon
the assessment by management of various factors affecting its mortgage loan portfolio, including current economic conditions, the
makeup of the portfolio based on credit grade, loan-to-value, delinquency status, historical credit losses, Company purchased mortgage
insurance and other factors deemed to warrant consideration. The allowance is maintained through ongoing provisions charged to
operating income and is reduced by loans that are charged off.
Mortgage Securities Mortgage securities represent beneficial interests the Company retains in securitization and resecuritization
transactions and include interest-only mortgage securities, prepayment penalty bonds, over collateralization bonds and subordinated
securities. Interest-only mortgage securities represent the contractual right to receive excess interest cash flows from a pool of securitized
mortgage loans. Interest payments received by the independent trust are first applied to the principal and interest bonds (held by outside
investors), servicing fees and administrative fees. The excess, if any, is remitted to the Company related to its ownership of the interestonly mortgage security. Prepayment penalty bonds give the holder the contractual right to receive prepayment penalties collected by
the independent trust on the underlying mortgage loans. Overcollateralization bonds represent the contractual right to excess principal
payments resulting from over collateralization of the obligations of the trust. Subordinated securities retained in resecuritizations represent
the contractual right to receive the remaining cash flows from the trust after the obligations to the outside bond holders have been
satisfied. When those obligations have been satisfied, the trust returns the transferred securities to the subordinated interest holders.
Mortgage securities are classified as available for sale and, accordingly, are reported at their estimated fair value with unrealized gains
and losses reported in accumulated other comprehensive income.
As previously described, mortgage securities represent the retained interests in certain components of the cash flows of the underlying
mortgage loans or mortgage securities transferred to securitization trusts. Each period as payments are received the payments
are applied to the amortized cost of the mortgage related security. The accretable yield rate is recorded as interest income with a
corresponding increase to the amortized cost of the mortgage security. On a periodic basis, the accretable yield for each mortgage
security is evaluated and, to the extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively.
Significant assumptions used in the calculation of the accretable yield include prepayment and loss rates on the underlying loans.
The fair value of mortgage securities retained by the Company is based on the present value of future expected cash flows to be
received. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, the market discount rates and
forward yield curves commensurate with the risks involved, are used in estimating future cash flows. To the extent that the amortized
cost of mortgage securities exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment
charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a
realized loss.
Corporate Advances to Borrowers Advances on behalf of borrowers for taxes, insurance and other customer service functions
are made by NovaStar Mortgage, Inc.
Mortgage Servicing Rights Originated mortgage servicing rights are recorded at allocated cost based upon the relative fair values
of the transferred loans and the servicing rights. Mortgage servicing rights are amortized in proportion to the projected net servicing
revenue over the expected life of the related mortgage loans. Periodically, the Company evaluates the carrying value of capitalized
mortgage servicing rights based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology,
is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of
the estimated fair value. For purposes of evaluating and measuring impairment of mortgage servicing rights the Company stratifies
the mortgage servicing rights based on their predominant risk characteristics. The significant risk characteristics considered by the
Company are loan type, period of origination, interest rate and prepayment penalties. The mortgage loans underlying the mortgage
servicing rights are pools of homogenous, non-conforming residential loans.
55
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Assets Acquired Through Foreclosure Real estate owned, which consists of residential real estate acquired in satisfaction
of loans, is carried at the lower of cost or estimated fair value less estimated selling costs. Adjustments to the loan carrying value
required at time of foreclosure are charged against the allowance for credit losses. Costs related to the development of real estate
are capitalized and those related to holding the property are expensed. Losses or gains from the ultimate disposition of real estate
owned are charged or credited to operating income.
Premiums for Mortgage Loan Insurance The Company uses lender paid mortgage insurance to mitigate the risk of loss on
loans that are originated. For those loans held in portfolio the premiums for mortgage insurance are expensed by the Company as the
cost of the premiums are incurred. For those loans sold in securitization transactions accounted for as a sale, the independent trust
assumes the obligation to pay the premiums and obtains the right to receive insurance proceeds.
Transfers of Assets A transfer of mortgage loans or mortgage securities in which the Company surrenders control over the financial
assets is accounted for as sale. When the Company retains control over transferred mortgage loans or mortgage securities, the
transaction is accounted for as a secured borrowing. When the Company sells mortgage loans or mortgage securities in securitization
and resecuritization transactions, it may retain one or more bond classes and servicing rights in the securitization. Gains and losses on
the assets transferred are recognized based on the carrying amount of the financial assets involved in the transfer, allocated between
the assets transferred and the retained interests based on their relative fair value at the date of transfer. To determine fair value, the
Company estimates fair value based on the present value of future expected cash flows estimated using management’s best estimate
of the key assumptions, including credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the
risks involved.
The following is a description of the methods used by the Company to transfer assets, including the related accounting treatment under
each method:
• Whole Loan Sales Whole loan sales represent loans sold with servicing released. Gains and losses on whole loan sales are
recognized in the period the sale occurs and the Company has determined that the criteria for sales treatment has been achieved
as they have surrendered control over the assets transferred. The Company generally has an obligation to repurchase whole loans
sold in circumstances in which the borrower fails to make the first payment. Additionally, the Company is also required to repay all
or a portion of the premium it receives on the sale of whole loans in the event that the loan prepays in its entirety in the first year.
The Company records the fair value of recourse obligations upon the sale of the mortgage loans.
• Loans and Securities Sold Under Agreements to Repurchase (Repurchase Agreements) Repurchase agreements represent legal
sales of loans or mortgage securities and an agreement to repurchase the loans or mortgage securities at a later date. Repurchase
agreements are accounted for as secured borrowings because the Company has not surrendered control of the transferred assets
as it is both entitled and obligated to repurchase the transferred assets prior to their maturity.
• Securitization Transactions The Company regularly securitizes mortgage loans by transferring mortgage loans to independent trusts
which issue securities to investors. The securities are collateralized by the mortgage loans transferred into the independent trusts.
The Company generally retains interests in some of the securities issued by the trust. Certain of the securitization agreements
require the Company to repurchase loans that are found to have legal deficiencies, subsequent to the date of transfer. The Company
is required to buy back any loan for which the borrower converts from an adjustable rate to a fixed rate. The fair values of these
recourse obligations are recorded upon the transfers of the mortgage loans. The Company also has the right, but not the obligation,
to acquire loans when they are 90 to 119 days delinquent and at the time a property is liquidated. As discussed above, the accounting
treatment for transfers of assets upon securitization depends on whether or not the Company has retained control over the transferred
assets. The Company records an asset and a liability on the balance sheet for the aggregate fair value of loans that it has a right to
call as of the balance sheet date.
56
• Resecuritization Transactions The Company also engages in resecuritization transactions. A resecuritization is the transfer of mortgage
securities that the Company has retained in previous securitization transactions from an independent trust. Similar to a securitization,
the trust issues securities that are collateralized by the mortgage securities transferred to the trust. Resecuritization transactions are
accounted for as either a sale or a secured borrowing based on whether or not the Company has retained or surrendered control over
the transferred assets. In the resecuritization transaction, the Company may retain an interest in a security that represents the right
to receive the cash flows on the underlying mortgage security collateral after the senior bonds, issued to third parties, have been
repaid in full.
Fee Income The Company receives fee income from several sources. The following describes significant fee income sources and the
related accounting treatment:
• Broker Fees Broker fees are paid by other lenders for placing loans with third party investors (lenders) and are based on negotiated
rates with each lender to whom the Company brokers loans. Revenue is recognized upon loan origination.
• Loan Origination Fees Loan origination fees represent fees paid to the Company by borrowers and are associated with the origination
of mortgage loans. Loan origination fees are determined based on the type and amount of loans originated. Loan origination fees
and direct origination costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan using the level
yield method. Loan origination fees and direct origination costs on mortgage loans held-for-sale are deferred and considered as part
of the carrying value of the loan when sold.
• Service Fee Income Service fees are paid to the Company by either the investor on mortgage loans serviced or the borrower. Fees
paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced and are recognized
in the period in which payments on the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees
related to loan servicing and include late fees, processing fees and, for loans held in portfolio, prepayment penalties. Revenue is
recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.
• Affiliated Branch Management Fees These fees are charged to affiliated mortgage brokers to manage their administrative operations,
which include providing accounting, payroll, human resources, loan investor management and license management. The amount
of the fees is agreed upon when entering a contractual agreement with affiliated mortgage brokers and are recognized as services
are rendered.
Stock-Based Compensation In accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation, the Company has elected to account for stock-based compensation under Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employee. Stock options are accounted for based on the specific terms of the options granted.
Options with variable terms, including those options for which the strike price has been adjusted and options issued by the Company
with attached dividend equivalent rights, result in adjustments to compensation expense to the extent the market price of the common
stock changes. No expense is recognized for options with fixed terms.
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The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition
provisions of SFAS No. 123, to stock-based employee compensation.
Net income, as reported
2002
2001
2000
$48,761
$32,308
$5,626
2,473
704
—
(600)
(318)
(142)
Add: Stock-based employee compensation expense included
in reported net income, net of related tax effects
Deduct: Total stock-based employee compensation expense determined
under fair value based method for all awards, net of related tax effects
Pro forma net income
$50,634
$32,694
$5,484
Basic – as reported
$
4.70
$
3.22
$ 0.51
Basic – pro forma
$
4.88
$
3.26
$ 0.49
Diluted – as reported
$
4.50
$
3.02
$ 0.50
Diluted – pro forma
$
4.68
$
3.06
$ 0.49
Earnings per share:
The following table summarizes the weighted average fair value of the granted options, determined using the Black-Scholes option
pricing model and the assumptions used in their determination.
2002
2001
2000
$16.07
$9.54
$2.63
Weighted average:
Fair value, at date of grant
Expected life in years
7.0
7.0
7.0
Annual risk-free interest rate
4.1%
5.0%
5.1%
Volatility
2.1
2.3
3.5
Dividend yield
6.0%
5.0%
5.0%
Income Taxes The Company is taxed as a Real Estate Investment Trust (REIT) under Section 856(c) of the Code. As a REIT, the
company generally is not subject to Federal income tax. To maintain its qualification as a REIT, the Company must distribute at least
90% of its REIT taxable income to its stockholders and meet certain other tests relating to assets and income. If the Company fails to
qualify as a REIT in any taxable year, the Company will be subject to federal income tax on its taxable income at regular corporate rates.
The Company may also be subject to certain state and local taxes. Under certain circumstances, even though the Company qualifies
as a REIT, federal income and excise taxes may be due on its undistributed taxable income. Because the Company has paid or will pay
dividends in amounts approximating its taxable income, no provision for income taxes has been provided in the accompanying financial
statements related to the REIT. However, NFI Holding Corporation has not elected REIT-status and files a consolidated federal income
tax return with its subsidiaries.
The Company has elected to treat NFI Holding Corporation and its subsidiaries as taxable REIT subsidiaries (each a “TRS”). In general,
a TRS of the Company may hold assets that the Company cannot hold directly and generally may engage in any real estate or non-real
estate related business. A TRS is subject to corporate federal income tax and will be taxed as a regular C corporation. However, special
rules do apply to certain activities between a REIT and a TRS. For example, a TRS will be subject to earnings stripping limitations on
the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excise tax on certain excess amounts to
58
ensure that (i) tenants who pay a TRS for services are charged an arm’s-length amount by the TRS, (ii) fees paid to a REIT by its TRS are
reflected at fair market value and (iii) interest paid by a TRS to its REIT is commercially reasonable. Securities of a TRS will constitute
non-real estate assets for purposes of determining whether at least 75% of a REIT’s assets consist of real estate. Under current law,
no more than 20% of a REIT’s total assets can consist of securities of one or more taxable REIT subsidiaries. As of December 31, 2002,
the amount of the Company’s assets attributable to its taxable REIT subsidiaries was less than 20%.
With respect to the Company’s taxable REIT subsidiaries, the Company records deferred tax assets and liabilities for the future tax
consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their
respective income tax bases. The Company believes the deferred tax asset recorded is recoverable and, therefore, no valuation
allowance has been recorded.
Net Income Per Share Basic income per share excludes dilution and is computed by dividing net income available to common
stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution
that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted
in the issuance of common stock that then shared in the earnings of the entity. Diluted EPS is calculated assuming all options and
warrants on the Company’s common stock have been exercised and the convertible preferred stock is converted, unless the exercise
would be anti-dilutive.
Derivative Instruments and Hedging Activity During 1998, the Financial Accounting Standards Board (FASB) issued SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities. As amended by SFAS No. 137, Accounting for Derivative Instruments
and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133 and SFAS No. 138, Accounting for Certain Derivative
Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133, SFAS No. 133 standardizes the accounting for
derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as
assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate
a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. SFAS No. 133 requires
derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings. The Company adopted SFAS
No. 133 on January 1, 2001 and recorded a charge to earnings of $1.7 million and an increase in accumulated other comprehensive
income of $34,000. The transition adjustments resulted from adjusting the carrying value of certain interest rate cap agreements to
their fair value.
The Company uses derivative instruments with the objective of hedging interest rate risk. Interest rates on liabilities of the Company
adjust frequently, while interest rates on the Company’s assets adjust annually, or not at all. The fair value of the Company’s derivative
instruments along with any margin accounts associated with the contracts are included in other assets. Any changes in fair value of
derivative instruments related to hedge effectiveness are reported in accumulated other comprehensive income. Changes in fair value
of derivative instruments related to hedge ineffectiveness and non-hedge activity are recorded as adjustments to earnings. For those
derivative instruments that do not qualify for hedge accounting, changes in the market value of the instruments are recorded as
adjustments to earnings.
Commitments to Originate, Purchase and Sell Mortgage Loans As commitments to originate, purchase and sell nonconforming mortgage loans are not readily convertible to cash and cannot readily be settled net, these commitments do not meet the
definition of a derivative under generally accepted accounting principles. Accordingly, they are not recorded in the consolidated financial
statements. Commitments to originate and sell conforming mortgage loans meet the definition of a derivative and are recorded at fair
value in the consolidated financial statements.
New Accounting Pronouncements During September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities—a Replacement of FASB Statement No. 125. Although SFAS No. 140 revised many of
the rules regarding securitizations, it continues to require an entity to recognize the financial and servicing assets it controls and the
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liabilities it has incurred and to derecognize financial assets when control has been surrendered in accordance with the criteria provided
in the Statement. This statement was effective for transfers and servicing of financial assets and extinguishments of liabilities occurring
after March 31, 2001 and was effective for recognition and reclassification of collateral for fiscal years ending after December 15,
2000. Disclosure provisions of SFAS No. 140 were implemented for the 2000 financial statements of the Company. The Company’s
securitization and resecuritization transactions were subject to the provisions of SFAS No. 140 beginning April 2001.
additional guidance on the disclosure of guarantees. The recognition and measurement provisions are effective for guarantees made or
modified after December 31, 2002. The disclosure provisions are effective for fiscal periods ending after December 15, 2002 and have
been implemented herein. The Company will adopt the measurement provisions of FIN No. 45 as required in 2003 and does not expect
a material impact on the consolidated financial statements. Significant guarantees that have been entered into by the company are
discussed in Note 14.
During 1999, the FASB issued Emerging Issues Task Force (EITF) No. 99-20, Recognition of Interest Income and Impairment on Purchased
and Retained Beneficial Interests in Securitized Financial Assets. Effective April 1, 2001, EITF No. 99-20 provides guidance on the recognition
of interest income from, and measurement of retained beneficial interests and was effective beginning April 1, 2001. The implementation
of EITF 99-20 did not have a material effect on the Company’s consolidated financial statements.
In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities. FIN No. 46 requires consolidation by business
enterprises of variable interest entities that meet certain requirements. The interpretation applies immediately to variable interest
entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date.
The Company will adopt the provisions of FIN No. 46 in 2003 and does not expect a material impact on the consolidated financial
statements based on the current structure of the Company’s securitizations.
During 2001, the FASB issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No.
141 requires the purchase method of accounting for business combinations and eliminates the pooling-of-interests method. Business
combinations consummated subsequent to June 30, 2001 are to be accounted for under the provisions of the new statement. SFAS
No. 142, which was effective for the Company on January 1, 2002, requires, among other things, the discontinuance of goodwill
amortization. In addition, the statement includes provisions for the reclassification of the useful lives of existing recognized
intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles
out of previously reported goodwill and identification of reporting units for the purpose of assessing potential future impairments of
goodwill. Implementation of these statements has had no impact on the Company’s financial statements.
In July 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting
and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs.
This Statement is effective for all financial statements issued for fiscal years beginning after June 15, 2002. The Company’s adoption
of SFAS No. 143 did not have a significant impact on its consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets. SFAS No. 144 addresses
financial accounting and reporting for the impairment or disposal of long-lived assets. The provisions of this Statement will be effective
for the Company’s financial statements issued for fiscal year 2003. The Company does not expect the adoption of SFAS No. 144 to
have a significant impact on its consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. The provisions of SFAS
No. 146 are effective for exit or disposal activities initiated after December 31, 2002. The Company’s adoption of SFAS No. 146 is
not expected to have a significant impact on its consolidated financial statements.
Reclassifications Reclassifications to prior year amounts have been made to conform to current year presentation.
Note 2. Mor tgage Loans
Mortgage loans, all of which are secured by residential properties, consisted of the following as of December 31, (in thousands):
2002
2001
$149,918
$226,960
2,994
4,630
152,912
231,590
(3,036)
(5,557)
$149,876
$226,033
$972,360
$138,074
11,273
1,453
$983,633
$139,527
Mortgage loans – held-in-portfolio:
Net unamortized premium
Amortized cost
Allowance for credit losses
Mortgage loans – held-in-portfolio
Mortgage loans – held-for-sale:
Net unamortized premium
Mortgage loans – held-for-sale
Activity in the allowance for credit losses is as follows for the three years ended December 31, 2002 (in thousands):
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, which amends
SFAS No. 123. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. Under the fair value based method, compensation cost for stock options is measured when
options are issued. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent and
more frequent disclosures in financial statements of the effects of stock-based compensation. The transition guidance and annual
disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted
in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim
periods beginning after December 15, 2002. The annual disclosure requirements have been implemented herein. The remaining
provisions of SFAS No. 148 are not expected to have a significant impact on the consolidated financial statements.
In November 2002, the FASB issued Financial Interpretation (FIN) No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others, which expands on the accounting guidance of Statements No. 5, 57 and 107 and
incorporates without change the provsisions of FIN No. 34, which is being superseded. FIN No. 45 requires a guarantor to recognize,
at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. It also provides
60
Balance, January 1
Amounts charged off, net of recoveries
Balance, December 31
2002
2001
2000
$5,557
$7,690
(432)
3,608
5,449
(2,089)
(5,741)
(8,864)
$3,036
$5,557
$ 7,690
$11,105
Recoveries were not significant in the three years ended December 31, 2002.
All mortgage loans serve as collateral for borrowing arrangements discussed in Note 5. The weighted-average interest rate on
mortgage loans as of December 31, 2002 and 2001 was 8.29% and 9.90%, respectively.
Collateral for 26% and 14% of the mortgage loans outstanding as of December 31, 2002 was located in California and Florida,
respectively. The Company has no other significant concentration of credit risk.
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N o t e 3 . M o r tgage Securities – Av a i l a b l e - f o r - S a l e
Details of loan securitization transactions on the date of the securitization are as follows (in thousands):
Available-for-sale mortgage securities consisted of the Company’s investment in the AAA-rated interest-only, prepayment penalty
and other subordinated securities that the Company issued. The primary bonds were sold to parties independent of the Company.
Management estimates their fair value by discounting the expected future cash flow of the collateral and bonds. The amortized cost,
unrealized gains and losses and estimated fair value of mortgage securities as of December 31, 2002 and 2001 were as follows
(in thousands):
Allocated Value of Retained Interests
Net Bond
Proceeds
Mortgage
Servicing Rights
Subordinated
Bond Classes
Value of
Loans Sold
Gain
Recognized
Year ended December 31, 2002:
NMFT Series 2002-3
$ 734,584
$2,939
$39,099
$ 750,003
$29,353
NMFT Series 2002-2
300,304
1,173
22,021
310,000
10,459
NMFT Series 2002-1
485,824
1,958
29,665
499,998
8,082
$1,520,712
$6,070
$90,785
$1,560,001
$47,894
Gross Unrealized
Amortized
Cost
Gains
Losses
Estimated
Fair Value
As of December 31, 2002
$102,665
As of December 31, 2001
54,594
$77,755
$1,541
$178,879
18,695
1,705
71,584
NMFT Series 2001-2
$ 785,509
$3,817
$36,942
$ 800,033
$12,745
NMFT Series 2001-1
407,372
1,837
22,628
415,067
8,985
$1,192,881
$5,654
$59,570
$1,215,100
$21,730
NMFT Series 2000-2
$ 332,566
$1,416
$20,137
$ 347,308
$ 6,811
NMFT Series 2000-1
225,168
1,577
13,233
237,042
2,936
$ 557,734
$2,993
$33,370
$ 584,350
$ 9,747
Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial
instruments. The Company expects the securities it owns as of December 31, 2002 to mature in one to five years.
All mortgage securities owned by the Company are pledged for borrowings as discussed in Note 5.
On September 26, 2001, the Company securitized interest-only and prepayment penalty securities and issued NovaStar CAPS
Certificates Series 2001-C1 in the amount of $29,250,000. A gain of $14.9 million was recognized on this transaction. A subordinated
security, valued by the Company at $8.2 million, was retained entitling the Company to receive cash flows of the collateral once the
primary bonds are paid. On October 25, 2002, the primary bonds were paid off and the interest-only and prepayment penalty securities
were transferred back to the Company by the trust.
In the securitizations, the Company retains interest-only and other subordinated interests in the underlying cash flows and servicing
responsibilities. The Company receives annual servicing fees approximating 0.50% of the outstanding balance and rights to future
cash flows arising after the investors in the securitization trusts have received the return for which they contracted. The investors and
securitization trusts have no recourse to the Company’s assets for failure of borrowers to pay when due. The value of the Company’s
interests is subject to credit, prepayment, and interest rate risks on the transferred financial assets.
Servicing fees received from the securitization trusts were $10.0 million, $4.9 million and $1.6 million for the years ended December
31, 2002, 2001 and 2000, respectively. No purchases of delinquent or foreclosed loans were made on securitizations in which the
Company did not maintain control over the mortgage loans transferred during the three years ended December 31, 2002.
Fair value of the subordinated bond classes at the date of securitization is measured by estimating the net present value of expected
cash flows of the loan collateral. Key economic assumptions used to project cash flows at the time of loan securitization during the
three years ended December 31, 2002 were as follows:
On November 5, 2002, the Company securitized interest-only and prepayment penalty securities and issued NovaStar CAPS Certificate
Series 2002-C1 in the amount of $68,000,000. The resecuritization was accounted for as a secured borrowing. In accordance
with SFAS 140, control over the transferred assets was not surrendered and thus the transaction was recorded as financing for the
mortgage securities.
As of December 31, 2002, key economic assumptions and the sensitivity of the current fair value of retained interests owned by the
Company to immediate adverse changes in those assumptions are as follows, on average for the portfolio (dollars in thousands):
Carrying amount/fair value of retained interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $178,879
Average life (in years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.8
Prepayment speed assumption (CPR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Fair value after a 10% increase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $173,968
Expected annual credit losses (percent of current collateral balance) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.8
Mortgage Loan Collateral for NovaStar Mortgage Funding Trust Series
2002-3
2002-2
2002-1
2001-2
2001-1
2000-2
2000-1
24%
24%
28%
28%
28%
28%
27%
Constant prepayment rate
Average life (in years)
3.09
3.13
2.60
2.61
2.54
2.81
2.88
Expected total credit losses, net of mortgage insurance
1.00%
1.60%
1.65%
1.20%
1.20%
1.00%
1.00%
Discount rate
30.0%
30.0%
30.0%
25.0%
20.0%
15.0%
15.0%
Residual cash flows discount rate (%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Fair value after a 500 basis point increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $168,606
Fair value after a 1000 basis point increase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $159,457
Market interest rates
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These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10%
variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair
value may not be linear. Also, in this table the effect of a variation in a particular assumption on the fair value of the retained interest
is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example,
increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract
the sensitivities.
N o t e 5 . B o r r owings
Short-term Borrowings The following tables summarize the Company’s repurchase agreements and warehouse agreements as of
December 31, 2002 and 2001 (dollars in thousands):
Repurchase agreements (indexed to one-month LIBOR)
Maximum
Borrowing Capacity
Rate
Days to
Reset
Balance
Average Daily Balance
During the Year
December 31, 2002:
The actual static pool credit loss as of December 31, 2002 was 0.13% and the projected static pool credit loss as of December 31,
2003 is 0.17%. Static pool losses are calculated by summing the actual and projected future credit losses and dividing them by the
original balance of each pool of assets.
The table below presents quantitative information about delinquencies, net credit losses, and components of securitized financial
assets and other assets managed together with them (in thousands):
December 31,
Total Principal Amount
of Loans (A)
2002
2001
Loans securitized
$2,586,493
Loans held for sale
965,118
Loans held in portfolio
155,683
Principal Amount of Loans
30 Days or More Past Due
2002
2001
$1,629,668
$125,700
131,639
37,466
239,741
28,743
$ 91,268
17,102
41,291
Net Credit Losses During
the Year Ended December 31,
2002
2001
$ 4,558
Agreement expiring March 31, 2003
1.88%
29
$ 40,650
Agreement expiring September 18, 2003
50,000
1.88
24
46,500
Agreement expiring October 28, 2003
50,000
1.88
27
10,914
200,000
2.38
13
84,320
150,000
2.38
1
107,705
300,000
2.42
10
264,658
Total repurchase agreements
$3,707,294
$2,001,048
$191,909
$149,661
$554,747
$1,968
$300,000
2.88%
10
$ 19,989
565
200,000
—
—
—
Agreement expiring July 30, 2002
200,000
—
—
—
50,000
2.37
29
40,000
Agreement expiring July 30, 2002
50,000
2.54
10
22,000
25,000
—
—
—
484
7,857(B)
$12,899
$800,000
5,811(B)
$8,344
(A) Includes assets acquired through foreclosure.
(B) Excludes mortgage insurance proceeds on policies paid by the Company and includes interest accrued in excess of 120 days for which the Company had discontinued interest accrued.
Total repurchase agreements
N o t e 4 . M o r tgage Ser vicing
The Company records mortgage servicing rights arising from the transfer of loans to the securitization trusts. The following schedule
summarizes the carrying value of mortgage servicing rights and the activity during 2002 and 2001 (in thousands):
$322,748
December 31, 2001:
Total loans managed or securitized
$ 50,000
$825,000
$ 81,989
Maximum
Borrowing Capacity
Rate
Days to
Reset
$125,000
2.74
Daily
$123,317
250,000
2.98
Daily
230,160
(indexed to one-month LIBOR)
200,000
2.51
Daily
117,312
Total warehouse agreements
$575,000
Warehouse agreements
Balance
$129,034
Average Daily Balance
During the Year
December 31, 2002:
2002
Balance, January 1
$6,445
Amount acquired in purchase of common stock of NFI Holding Corporation
2001
$
—
—
2,922
Amount capitalized in connection with transfer of loans to securitization trusts
6,070
5,654
Amortization
(4,609)
(2,131)
$7,906
$6,445
Balance, December 31
(indexed to Federal funds rate)
Agreement expiring December 6, 2003
$470,789
$114,639
December 31, 2001:
The estimated fair value of the servicing assets aggregated $12.6 million and $6.6 million at December 31, 2002 and December 31,
2001, respectively. The fair value is estimated by either discounting estimated future cash flows from the servicing assets using discount
rates that approximate current market rates. The fair value as of December 31, 2002 was determined utilizing a 15% discount rate,
credit losses net of mortgage insurance (as a percent of current principal balance) of 1.8% and an annual prepayment rate of 40%.
Mortgage servicing rights are amortized over the expected weighted average life of the related loans. The estimated amortization
expense for 2003, 2004 and 2005 is $4.9 million, $2.8 million and $0.2 million, respectively. All mortgage servicing rights will be
amortized by the end of 2005.
64
(indexed to Federal funds rate)
$ 75,000
3.32
Daily
$ 46,111
60,000
3.47
Daily
15,250
Agreement expiring February 19, 2002
Total warehouse agreements
$135,000
65
$ 61,361
$ 50,448
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The Company’s mortgage loans and securities are pledged as collateral on borrowings. All short-term financing arrangements require
the Company to maintain minimum tangible net worth, meet a minimum equity ratio test and comply with other customary debt
covenants. The Company complies with all debt covenants.
Repurchase agreements generally contain margin calls under which a portion of the borrowings must be repayed if the fair value of the mortgage
securities or mortgage loans collateralizing the repurchase agreements, falls under a predefined ratio to the borrowings outstanding.
Asset-backed Bonds (ABB) The Company issued ABB secured by its mortgage loans as a means for long-term financing. For
financial reporting and tax purposes, the mortgage loans held in portfolio as collateral are recorded as assets of the Company and the
ABB are recorded as debt. Interest and principal on each ABB is payable only from principal and interest on the underlying mortgage
loans collateralizing the ABB. Interest rates reset monthly and are indexed to one-month LIBOR. The estimated weighted-average
months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations.
However, the Company retains the option to repay the ABB, and reacquire the mortgage loans, when the remaining unpaid principal balance
of the underlying mortgage loans falls below 35% of their original amounts for issue 1997-1 and 25% on 1997-2, 1998-1 and 1998-2.
On November 5, 2002, the Company issued ABB in the amount of $68 million secured by the AAA-IO and prepayment penalty mortgage
securities of NMFT 2001-1 and NMFT 2001-2 as a means for long-term financing. The mortgage securities are recorded as assets of the
Company and the ABB are recorded as debt. The performance of the mortgage loan collateral underlying these securities, as presented
in Note 2 directly affects the performance of the 2002-C1 bond. The interest rate is fixed at 7.15% and the estimated weighted average
months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations.
Following is a summary of outstanding ABB and related loans (dollars in thousands):
Interest
Rate
The Company’s objective and strategy for using derivative instruments is to mitigate the risk of increased costs on its variable rate liabilities
during a period of rising rates. The Company’s primary goals for managing interest rate risk are to maintain the net interest margin
between its assets and liabilities and diminish the effect of changes in general interest rate levels on the market value of the Company.
The derivative instruments used by the Company to manage this risk are interest rate caps and interest rate swaps. Interest rate caps
are contracts in which the Company pays either an upfront premium or quarterly premium to a counterparty. In return, the Company
receives payments from the counterparty when interest rates rise above a certain rate specified in the contract. The interest rate
swap agreements to which the Company is party stipulate that the Company pay a fixed rate of interest to the counterparty and the
counterparty pays the company a variable rate of interest based on the notional amount of the contract. The liabilities the Company
hedges are asset-backed bonds and borrowings under its warehouse, mortgage loan and mortgage security repurchase agreements
as discussed in Note 5.
All of the Company’s derivative instruments that meet the hedge accounting criteria of SFAS No. 133 are considered cash flow hedges.
The Company does have some derivative instruments that do not meet the requirements for hedge accounting as of December 31,
2002. However, they contribute to the Company’s overall risk management strategy by serving to reduce interest rate risk on average
short-term borrowings used to fund loans held for sale. The following tables present derivative instruments as of December 31, 2002
and 2001 (dollars in thousands):
Notional
amount
Fair Value
Maximum Days
to Maturity
$ 435,000
$(11,267)
815
1,648,486
(6,977)
1,090
$2,083,486
$(18,244)
$ 335,000
$ (8,044)
839
595,000
(1,804)
1,090
$ 930,000
$ (9,848)
Asset-backed Bonds
Remaining
Principal
N o t e 6 . D e r i v a t i v e I n s t r uments and Hedge Activity
Mortgage Loans
Remaining
Principal (A)
Weighted
Average Coupon
Cash flow hedge derivative instruments
Estimated Weighted
Average Months to Call
Non-hedge derivative instruments
Total derivative instruments
NovaStar Home Equity Series:
Cash flow hedge derivative instruments
Collateralizing Mortgage Loans:
Issue 1997-1
$ 17,147
1.88%
Issue 1997-2
20,714
1.88
Issue 1998-1
39,692
1.82
Issue 1998-2
65,906
1.63
57,219
7.15 (B)
$19,076
10.27%
—
22,812
10.51
—
44,363
10.02
—
69,432
9.85
—
(B)
(B)
(B)
Collateralizing Mortgage Securities:
Issue 2002-C1
Unamortized debt issuance costs, net
(986)
Non-hedge derivative instruments
Total derivative instruments
During the three years ended December 31, 2002, the Company recognized $10,294,000, $2,278,000 and $4,000, respectively, in net
expense on derivative instruments qualifying as cash flow hedges, which is recorded as a component of interest expense. The 2002
net expense on derivative instruments is made up of the following components (in thousands):
$199,692
Net settlement costs
NovaStar Home Equity Series:
Other amortization
Collateralizing Mortgage Loans:
103
Total net expense on cash flow hedges
Issue 1997-1
$ 29,942
Issue 1997-2
30,629
2.44
Issue 1998-1
59,751
2.33
Issue 1998-2
98,790
2.31
Unamortized debt issuance costs, net
$(10,397)
2.41%
$33,035
10.90%
—
33,525
10.79
—
68,326
10.45
—
104,855
10.18
9
$(10,294)
The net amount included in other comprehensive income expected to be reclassified into earnings within the next twelve months is
a charge to earnings of approximately $8.8 million.
(64)
The Company’s derivative instruments involve, to varying degrees, elements of credit and market risk in addition to the amount
recognized in the consolidated financial statements.
$219,048
(A) Includes assets acquired through foreclosure.
(B) Collateral for the 2002-C1 asset backed bond is the AAA-IO and prepayment penalty mortgage securities of NMFT 2001-1 and NMFT 2001-2.
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Credit Risk The Company’s exposure to credit risk on derivative instruments is limited to the cost of replacing contracts should the
counterparty fail. The Company seeks to minimize credit risk through the use of credit approval and review processes, the selection of
only the most creditworthy counterparties, continuing review and monitoring of all counterparties, exposure reduction techniques and
thorough legal scrutiny of agreements. Before engaging in negotiated derivative transactions with any counterparty, the Company has
in place fully executed written agreements. Agreements with counterparties also call for full two-way netting of payments. Under these
agreements, on each payment exchange date all gains and losses of counterparties are netted into a single amount, limiting exposure
to the counterparty to any net receivable amount due.
Market Risk The potential for financial loss due to adverse changes in market interest rates is a function of the sensitivity of each
position to changes in interest rates, the degree to which each position can affect future earnings under adverse market conditions, the
source and nature of funding for the position, and the net effect due to offsetting positions. The derivative instruments utilized leave
the Company in a market position that is designed to be a better position than if the derivative instrument had not been used in interest
rate risk management.
Other Risk Considerations The Company is cognizant of the risks involved with derivative instruments and has policies and
procedures in place to mitigate risk associated with the use of derivative instruments in ways appropriate to its business activities,
considering its risk profile as a limited end-user.
Note 8. Stockholders’ Equity
Terms of the Class B, convertible preferred stock issued in 1999 allowed the Company to redeem the shares for $7.00 per share
beginning April 1, 2002. In February 2002, the Company notified the preferred shareholders of its intent to redeem all of the outstanding
preferred shares at the earliest possible time. On February 21, 2002, the preferred shareholders exercised their options to convert to
common shares.
As of December 31, 2001, the Company had 1,162,731 warrants outstanding for the purchase of Company common stock. On January
30, 2002, warrant holders surrendered 350,000 warrants with an exercise price of $6.94 in a “cashless” exchange for 210,703
shares of the Company’s common stock valued at $17.43 per share. On April 5, 2002, the Company acquired the remaining 812,731
warrants with an exercise price of $4.56 from warrant holders for $9.5 million.
The Company’s Board of Directors has approved the purchase of up to $9,000,000 of the Company’s common stock. No shares were
purchased in 2002. During the year ended December 31, 2001, 115,147 shares were purchased with an aggregate purchase price of
$655,000. The purchased shares have been returned to the Company’s authorized but unissued shares of common stock. All common
stock purchases are charged against additional paid-in capital.
Following is a rollforward of accumulated other comprehensive income for the three years ended December 31, 2002 (in thousands):
N o t e 7 . F a i r Va l u e o f F i n a n c i a l I n s t r u m e n t s
Available-for-sale
Securities
The following disclosure of the estimated fair value of financial instruments presents amounts that have been determined using available
market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to
develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that
could be realized in a current market exchange. The use of different market assumptions or estimation methodologies could have a
material impact on the estimated fair value amounts.
The estimated fair values of the Company's financial instruments are as follows as of December 31, (in thousands):
2002
Carrying Value
2001
Fair Value
Carrying Value
Fair Value
Balance, January 1, 2000
$
Held-for-sale
Held-in-portfolio
Mortgage securities - available-for-sale
$983,633
$995,320
$139,527
$143,009
149,876
151,954
226,033
227,071
178,879
178,879
71,584
71,584
7,906
12,617
6,445
6,647
—
$
242
9,926
—
9,926
Other comprehensive income (loss)
9,926
—
9,926
—
10,168
10,168
Change in unrealized gain (loss)
21,768
(9,882)
11,886
Implementation of SFAS No. 133
—
34
34
Net settlements reclassified to earnings
—
2,087
2,087
Realized gain reclassified to earnings
(14,946)
Mortgage loans
$
Total
Other amortization
Financial assets:
242
Derivative
Instruments Used
in Cash Flow Hedges
—
(14,946)
—
(52)
(52)
6,822
(7,813)
(991)
16,990
(7,813)
9,177
55,649
(12,185)
43,464
Net settlements reclassified to earnings
—
10,397
10,397
Other amortization
—
(103)
(103)
55,649
(1,891)
53,758
$72,639
$(9,704)
$62,935
Financial liabilities:
Borrowings:
Short-term
Asset-backed bonds
Derivative instruments
1,025,536
1,025,536
143,350
143,350
199,692
199,352
219,048
218,131
(18,244)
(18,244)
(9,848)
(9,848)
The fair value of mortgage assets, derivative instruments and borrowings is estimated by discounting projected future cash flows at
appropriate rates. Expected prepayments are used in estimating the fair value of mortgage assets. The fair values of cash and cash
equivalents and accrued interest receivable and payable approximates their carrying value.
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N o t e 9 . Tr a n s a c t i o n s w i t h F o u n d e r s
In connection with the initial formation and capitalization of the Company, the two founders acquired 216,666 shares of common stock
along with warrants to acquire 216,666 additional shares in exchange for non-recourse forgivable promissory notes. Pursuant to the
terms of the agreements, the notes were to be forgiven if certain incentive targets were met. The targets were met in 1997, and
notes related to 72,222 shares were forgiven. The incentive targets were not met in 1998, 1999, or 2000 and, accordingly, no debt
forgiveness occurred in those years. For accounting purposes, the arrangement has been accounted for as a restricted stock award,
and the notes receivable included in the accompanying consolidated balance sheets have been adjusted to an amount equal to the fair
value of the remaining unearned shares at each balance sheet date. The Company added $260,000 of accrued interest recognized in
1997 on these notes from the founders to the principal of new notes. The warrants were not exercised and expired in 2001.
During 1998, the founders exercised options to acquire 289,332 shares of common stock in exchange for non-recourse promissory
notes aggregating $4,340,000.
The Company advanced $584,000 to the founders for the payment of their personal tax liability arising from the 1997 forgiveness
referred to above and advanced $70,000 in order for the founders to inject capital into NFI Holding Corporation in 1999. Additionally,
accrued interest balances related to the borrowings above aggregated $579,000 at December 31, 2000 and December 31, 1999.
Following is a summary of the Company’s consolidated operating results for the year ended December 31, 2001 and unaudited pro
forma results for the years ended December 31, 2000 as though the acquisition of the common stock of NFI Holding Corporation had
occurred at the beginning of that period:
Interest income
2001
Pro Forma 2000
$57,904
$60,815
Interest expense
28,588
42,907
29,316
17,908
(3,608)
(5,623)
Net interest income
25,708
12,285
Gain (loss) on derivative instruments and sales of mortgage assets
34,616
13,967
Fee income
20,204
9,908
Other income, net
(9)
2,181
46,505
32,715
34,014
5,626
No interest was recorded or received by the Company during 2001 and 2000 relating to the above notes. Interest income recorded by
the Company related to the notes aggregated $496,000 in 1999. Interest paid by the founders aggregated $177,000 in 1999.
(1,706)
Net income
32,308
5,626
On January 1, 2001, the Company and its founders entered into a series of transactions, which resulted in a significant modification
of the transactions described above. The founders returned the 289,332 shares of common stock acquired in 1998 and the Company
cancelled the related non-recourse debt. Additionally, the Company purchased the voting common stock of NFI Holding Corporation from
the founders for $370,000. The number of common shares purchased from the founders was 1,000 at a $0.01 par value. This business
combination was treated under the purchase accounting method. As a result of this purchase, NFI Holding Corporation became a
wholly-owned subsidiary of the Company on January 1, 2001. The Company also repurchased the 72,222 shares acquired by the
founders in 1997, paying $271,000.
Dividends on preferred shares
(5,025)
(2,100)
$27,283
$ 3,526
$
3.22
$
0.51
$
3.02
$
0.50
The founders used the $641,000 received from the sale of NFI Holding Corporation and Company common stock to repay a portion of
their obligations described above. The remaining obligations, aggregating $1,393,000 have been rewritten into new non-recourse, non
interest-bearing promissory notes. Those notes will be forgiven and charged to expense in equal installments over 10 years as long as
the Company employs the founders on December 31st of each year. The notes will be forgiven in full in the event of a change in control.
During the years ended December 31, 2002 and 2001, the Company recognized $139,000 in compensation expense related to these
notes. The founders have each pledged 72,222 shares of common stock as collateral for these loans. The activity on January 1, 2001
can be summarized as follows (in thousands):
Balance of forgivable notes, December 31, 2000
$6,374
Cash received from founders
(641)
Return of shares subject to non-recourse notes
N o t e 1 0 . I n c o m e Taxes
The components of income tax expense (benefit) allocated to earnings are as follows (in thousands):
For the Year Ended
December 31, 2002
Current
$ 2,621
Deferred
(4,652)
Total income tax expense (benefit)
$(2,031)
The difference between expected income tax benefit computed at the federal statutory rate of 34% and actual income tax benefit
recorded at the taxable REIT subsidiary is as follows (in thousands):
(4,340)
Balance of forgivable notes, January 1, 2001
For the Year Ended
December 31, 2002
$1,393
Income tax at statutory rate (taxable REIT subsidiary)
$(3,755)
State income taxes
(442)
Nondeductible expenses
117
Unrealized gain on security sale to REIT
805
Other
1,244
Total income tax expense (benefit)
70
—
$(2,031)
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The tax effects of temporary differences that give rise to the significant portions of the deferred tax assets and liabilities are as follows
(in thousands):
For the Year Ended
December 31, 2002
Deferred tax assets:
Unrealized loss on derivative instruments
2002
2001
Shares
Weighted
Average Price
Outstanding at the beginning of year
539,420
Granted
157,000
2000
Shares
Weighted
Average Price
Shares
Weighted
Average Price
$ 9.38
541,910
24.55
112,500
$ 7.63
357,720
$10.16
13.45
249,500
3.74
$3,108
Exercised
(177,625)
6.09
(113,250)
5.60
(10,000)
1.26
Excess inclusion
2,383
Canceled
(2,460)
16.50
(1,740)
18.00
(55,310)
7.57
Net operating losses
1,368
SFAS 133 unrealized loss
1,396
Other
991
Deferred tax asset
9,246
Outstanding at the end of year
516,335
$14.94
539,420
$9.38
541,910
$ 7.63
Exercisable at the end of year
147,210
$15.25
203,045
$12.37
184,745
$11.63
Compensation expense relating to
variable awards, in thousands
Deferred tax liabilities:
SFAS 115 unrealized gain
3,576
3,004
Other
200
Deferred tax liability
6,780
Net deferred tax asset
$2,466
The Company has Federal net operating loss carryforwards as of December 31, 2002 of approximately $3.4 million that will expire
in 2022, if not utilized.
$2,473
$704
Certain options granted during 2002, 2001 and 2000 were granted with DERs. In December 2001, the Company’s Board of Directors
approved that certain existing and all future stock option grants have DERs attached to them. Under the terms of the DERs, a recipient
is entitled to receive additional shares of stock upon the exercise of options. The DERs accrue at a rate equal to the number of options
outstanding times the dividends per share amount at each dividend date. The accrued DERs convert to shares based on the stock’s
fair value on the dividend declaration date. Certain of the options exercised in 2002, 2001 and 2000 had DERs attached to them when
issued. As a result of these exercises, an additional 1,613, 889 and 838 shares of common stock were issued in 2002, 2001 and
2000, respectively. As discussed in Note 9, the Company’s two founders exercised options to acquire 289,332 shares of common
stock in 1998, which were returned to the Company January 1, 2001.
The following table presents information on stock options outstanding as of December 31, 2002:
Note 11. Stock Option Plan
The Company's 1996 Stock Option Plan (the Plan) provides for the grant of qualified incentive stock options (ISOs), non-qualified stock
options (NQSOs), deferred stock, restricted stock, performance shares, stock appreciation and limited stock awards and dividend
equivalent rights (DERs). ISOs may be granted to the officers and employees of the Company. NQSOs and awards may be granted
to the directors, officers, employees, agents and consultants of the Company or any subsidiaries. Under the terms of the Plan, the
number of shares available for issuance is equal to 10% of the Company’s outstanding common stock. Individuals who receive awards
under the Plan will vest in those awards ratably over a four-year period. Unless previously terminated by the Board of Directors, the
Plan will terminate on September 1, 2006.
All options have been granted at exercise prices greater than or equal to the estimated fair value of the underlying stock at the date of
grant. Outstanding options vest over four years and expire ten years after the date of grant. The following table summarizes option
activity under the 1996 Plan for 2002, 2001 and 2000, respectively:
Outstanding
Exercisable
Exercise Price
Quantity
Weighted Average Remaining
Contractual Life (years)
Weighted Average
Exercise Price
Quantity
Weighted Average
Exercise Price
$3.06 – $5.88
143,375
7.95
$ 3.75
13,625
$6.38 - $15.82
125,750
8.68
13.32
35,875
$ 3.71
11.95
$18.00 - $25.93
247,210
7.93
22.26
97,710
18.07
516,335
8.12
$14.94
147,210
$15.25
N o t e 1 2 . S e g m e n t R e p o r ting
The Company reviews, manages and operates its business in three segments. These business segments are: mortgage portfolio
management, mortgage lending and loan servicing and branches. Mortgage portfolio management operating results are driven from
the income generated on the assets we manage less associated management costs. Mortgage lending and loan servicing operations
include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service our
on and off -balance sheet loans (See Note 2). Branches include the collective income generated by NovaStar Home Mortgage brokers
and the associated operating costs. Also, the corporate-level income and costs to support the NHMI branches as well as the LLC
branches is represented in our branches segment.
The Company’s operations were restructured into this decentralized organization structure beginning January 1, 2001 as the branches
became more significant to the overall performance of the Company. Prior to 2001, the Company managed its operations under one
industry segment: the origination, servicing and management of non-conforming mortgage loans. As such, it is not practicable to provide
segment information for 2000.
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Following is a summary of income and assets by the Company’s primary operating units for the year ended December 31, 2002 and
2001 (in thousands):
For the Year Ended December 31, 2002:
Interest income
Mortgage Portfolio
Management
$ 68,183
Mortgage Lending
and Loan Servicing
$
38,960
Branches
$
—
Total
$ 107,143
Interest expense
(15,650)
(22,946)
—
(38,596)
52,533
16,014
—
68,547
432
—
—
432
(791)
54,096
—
53,305
—
13,475
20,355
33,830
(23,691)
—
(25,973)
1,013
62
1,183
Provision for losses
Gains (losses) on sales of mortgage loans
Fee income
(2,282)
Other income
108
(6,449)
Income before income tax
43,551
—
Income tax benefit (expense)
Net income
$ 43,551
2002
2001
Loan servicing fees
$1,074
$1,573
Administrative fees
449
704
Intercompany interest income
(8,637)
(3,931)
Guaranty, commitment, loan sale and securitization fees
(6,001)
(3,871)
2001
2000
Amounts paid to mortgage lending and servicing from mortgage portfolio :
Amounts received from mortgage lending and servicing to mortgage portfolio:
Note 13. Supplemental Disclosure of Cash Flow Infor mation
(18,840)
(84,594)
(in thousands):
1,602
1,577
46,730
Cash paid for interest
$ 37,546
$ 28,918
$ 34,610
3,372
(1,341)
Cash paid for taxes
$ 3,581
$
684
$
2
Dividends payable
$ 16,768
$ 4,758
$
525
Securities retained in securitizations
$(90,785)
$(59,570)
$(33,370)
Retention of mortgage servicing rights
$ 6,070
$ 5,654
$ 2,993
Surrender of warrants
$ 3,673
$
$
Assets acquired through foreclosure
$ 8,417
$ 20,159
(59,305)
$
Intersegment revenues and expenses that were eliminated in consolidation were as follows (in thousands):
4,974
$
236
2,031
$
2002
48,761
Non-cash items:
December 31, 2002:
Total assets
For the Year Ended December 31, 2001:
Interest income
$387,600
Mortgage Portfolio
Management
$ 38,306
Interest expense
$1,053,264
Mortgage Lending
and Loan Servicing
$
19,513
$11,633
$1,452,497
Branches
$
85
Total
$
(18,970)
(9,618)
—
(28,588)
Net interest income
19,336
9,895
85
29,316
Provision for losses
(3,608)
—
—
(3,608)
Gains (losses) on sales of mortgage loans
Fee income
Other income (expense)
14,745
22,431
171
37,347
—
3,453
16,751
20,204
—
(2,731)
—
(2,731)
639
(648)
—
(9)
(3,681)
27,431
Net income
(26,573)
5,827
(1,385)
$ 26,046
(16,251)
(321)
$
5,506
(46,505)
756
756
—
$ 34,596
Non-cash activities related to the acquisition of common stock of NFI Holding Corporation on January 1, 2001 were as follows
(in thousands):
2001
Operating activities:
Increase in mortgage loans held-for-sale
$(81,733)
Increase in other assets
$(11,132)
Decrease in other liabilities
$ (9,422)
34,014
—
$
—
57,904
(1,706)
$
32,308
Investing activities:
Increase in real estate owned
$
(892)
December 31, 2001:
Total assets
$344,676
$152,593
$15,111
$ 512,380
Financing activities:
Increase in borrowings
$ 36,900
Non-cash financing activities related to founders’ notes receivable:
74
Decrease in founders’ notes receivable
$ 4,340
Decrease in additional paid-in capital
$ (4,340)
75
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Note 14. Commitments, Guarantees and Contingencies
The Company makes commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell
mortgage loans to third parties. At December 31, 2002, the Company had outstanding commitments to originate, purchase and sell
loans of $108 million, $16 million and $98 million, respectively. The Company leases other office space under various operating lease
agreements. Rent expense for 2002, 2001 and 2000, aggregated $2.4 million, $1.5 million and $1.3 million respectively. Future
minimum lease commitments under those leases are as follows (in thousands).
Lease Obligations
2003
$4,395
2004
2,849
2005
1,750
2006
1,471
2007
1,302
Thereafter
1,396
On August 12, 2002, the Company entered into a lease agreement for its new corporate headquarters in Kansas City, Missouri. Under
this agreement, the lessor agreed to repay the Company for certain existing lease obligations. The Company received approximately
$62,000 related to this agreement in 2002 and expects to receive approximately $2.3 million in future payments through 2007 from
the lessor unless the properties we previously occupied are subleased.
The Company has also entered into various sublease agreements for office space formerly occupied by the Company. The Company
received approximately $704,000 in 2002 related to these agreements and expects to receive approximately $501,000 in future
payments through 2004.
In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been sold with
recourse and are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. The Company sold
loans with recourse for borrower defaults totaling $142.2 million and $73.3 million in 2002 and 2001, respectively. The Company’s
reserve related to these guarantees totaled $29,000 and $25,000 as of December 31, 2002 and 2001, respectively.
2002, 2001 and 2000, respectively. In conjunction with the use of the Company’s mortgage broker license, the Company is contingently
liable for limited representations and warrantees of the affiliated branches as well as certain operating liabilities in the event that the
LLCs are unable to meet their obligations upon dissolution. The Company requires that the branch managers maintain a reserve with
the Company to cover such obligations. Historically, the amounts that the Company has been required to pay as a result of these
arrangements have been insignificant. The Company records an estimate of obligations regarding affiliated branch arrangements in
the consolidated financial statements.
N o t e 1 6 . Tr a n s a c t i o n s W i t h a n d C o n d e n s e d F i n a n c i a l S t a t e m e n t s
of NFI Holding Corporation and Subsidiaries
The Company has executed agreements with NFI Holding Corporation and its wholly owned subsidiary, NovaStar Mortgage, Inc. These
agreements include loan servicing support, financing commitment and guaranty spread agreements. In addition, the Company entered
into a securitization consulting agreement whereby NovaStar Mortgage pays a fee to the Company for expertise in negotiating and
coordinating the securitization transactions executed by NovaStar Mortgage. NovaStar Mortgage also services loans held in the
Company’s portfolio. Fees for these agreements are based on transaction volumes. During 2000, the Company paid NovaStar
Mortgage $3,127,000 under these agreements and received $3,106,000. Net fees under these agreements are recorded as a
component of “other income and expense.”
Note 17. Earnings Per Share
The computations of basic and diluted earnings per share for the years ended December 31, 2002, 2001 and 2000 are as follows
(in thousands except per share amounts):
2002
2001
$48,761
$32,308
$5,626
10,379
5,739
6,851
—
4,286
4,286
10,379
10,025
11,137
Stock options
262
189
6
Warrants
189
477
—
10,830
10,691
11,143
$4.70
$3.22
$0.51
$4.50
$3.02
$0.50
Numerator
Denominator:
Weighted average common shares outstanding – basic:
Common shares outstanding
In the ordinary course of business, the Company sells loans with and without recourse for borrower defaults that may have to be
subsequently repurchased due to defects in the loan origination process. The Company typically guarantees to cover investor losses
should origination defects occur. The defects are categorized as documentation and underwriting errors, judgments, early payment
defaults and fraud. If a defect is identified, the Company is required to repurchase the loan. As of December 31, 2002, the Company
had loans sold without recourse with an outstanding principal balance of $2.6 billion.
In the normal course of its business, the Company is subject to various legal proceedings and claims, the resolution of which, in the
opinion of management, will not have a material adverse effect on the Company's financial condition or results of operations.
2000
Convertible preferred stock
Weighted average common shares outstanding – basic
Weighted average common shares outstanding – dilutive:
Weighted average common shares outstanding – dilutive
Note 15. Af filiated Branches
As discussed in Note 1, the Company is party to LLC agreements for the purpose of establishing affiliated branches. As of December
31, 2002 and 2001, there were 207, and 108 such affiliated branches. For the years ended December 31, 2002, 2001 and 2000, the
Company recorded fee income aggregating $5.2 million, $1.9 million and $97,000, respectively, for providing administrative services for
affiliated branches. During 2002, 2001 and 2000, the aggregate amount of loans brokered by affiliated branches were approximately
$2.2 billion, $710.3 million and $26.2 million, respectively. Of those amounts, approximately $399.6 million, $110.5 million and
$5.1 million, respectively, were acquired by the Company’s mortgage subsidiary. The aggregate premiums paid by the Company for
loans brokered by the affiliated branches were approximately $5.1 million, $1.2 million and $28,000 for the years ended December 31,
76
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Page 78
The following stock options and warrants to purchase shares of common stock were outstanding during each period presented, but were
not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of
the common shares for the periods presented, therefore, the effect would be antidilutive:
Independent Auditors’ Report
2002
Number of stock options and warrants (in thousands)
Weighted average exercise price
Note 18.
2001
2000
150
210
5,706
$24.99
$16.33
$9.97
To the Board of Directors and Stockholders of
NovaStar Financial, Inc.
Kansas City, Missouri
Condensed Quar terly Financial Infor mation (unaudited)
Following is condensed consolidated quarterly operating results for the Company (in thousands, except per share amounts):
2002 Quarters
Net interest income
2001 Quarters
First
Second
Third
Fourth
First
Second
Third
Fourth
$9,689
$15,443
$16,586
$26,829
$5,535
$6,901
$ 9,149
$7,731
133
(379)
(383)
197
480
1,279
879
970
We have audited the accompanying consolidated balance sheets of NovaStar Financial, Inc. and subsidiaries (the “Company”) as of
December 31, 2002 and 2001, and the related consolidated statements of income, stockholders’ equity, and cash flows for the years
then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to
express an opinion on these consolidated financial statements based on our audit. The consolidated financial statements of the
Company for the year ended December 31, 2000 were audited by other auditors whose report, dated February 9, 2001, expressed
an unqualified opinion on those financial statements.
Income before income tax and cumulative
effect of a change in accounting principle
Gain on sales of mortgage assets
Gain (loss) on derivative instruments
Income tax benefit (expense)
10,221
7,752
11,359
17,398
4,719
4,188
18,936
6,171
4,630
15,993
17,293
15,389
5,023
4,540
22,240
5,544
4,692
(12,336)
(13,245)
(5,084)
—
—
(3,255)
524
(1,300)
2,638
840
(147)
—
—
—
—
Cumulative effect of a change in
accounting principle
Net income
Dividends on preferred stock
—
—
—
—
1,706
—
—
—
8,921
10,390
12,199
17,251
3,013
4,188
18,936
6,171
—
—
—
—
525
557
2,505
1,438
$8,921
$10,390
$12,199
$17,251
$2,488
$3,631
$16,431
$4,733
$0.87
$1.00
$1.17
$1.66
$0.47
$0.42
$1.89
$0.61
—
—
—
—
—
—
—
$0.87
$1.00
$1.17
$1.66
$0.30
$0.42
$1.89
$0.61
$0.80
$0.97
$1.14
$1.62
$0.47
$0.40
$1.76
$0.56
—
—
—
—
(0.17)
—
—
—
$0.80
$0.97
$1.14
$1.62
$0.30
$0.40
$1.76
$0.56
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, such 2002 and 2001 consolidated financial statements present fairly, in all material respects, the financial position
of the Company as of December 31, 2002 and 2001, and the results of its operations and its cash flows for the years then ended in
conformity with accounting principles generally accepted in the United States of America.
Basic earnings per share – before cumulative
effect of a change In accounting principle
Basic loss per share due to cumulative
(0.17)
February 14, 2003
Diluted earnings per share – before cumulative
Diluted loss per share due to cumulative
78
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Page 80
Corporate Information
Registrar and Transfer Agent
Annual Meeting
UMB Bank N.A.
928 Grand Boulevard
13th Floor
Kansas City, Missouri 64106
816.860.7786
10:00 a.m. May 29, 2003
8140 Ward Parkway, Suite 300
Kansas City, MO 64114
816.237.7000
Stock Information
Counsel
Our common stock is listed on the New York Stock Exchange
(NYSE) under the symbol “NFI”. Following are the high and low
stock prices (as reported by the NYSE) and cash dividends for
the quarterly periods of 2001 and 2002.
Period
High
Low
Dividend
$ 6.20
$ 3.75
$ —
8.50
5.55
0.13
Tobin & Tobin
San Francisco, California
Jeffers, Shaff & Falk, LLP
Irvine, California
Independent Accountants
2001:
January 1 – March 31
April 1 – June 30
July 1 – September 30
11.80
8.05
0.36
October 1 – December 31
18.10
10.35
0.47
Deloitte & Touche LLP
2002:
January 1 – March 31
19.50
15.00
0.80
April 1 – June 30
35.75
18.90
0.90
July 1 – September 30
35.49
19.00
1.00
October 1 – December 31
32.80
18.01
1.60
Filings with the Securities and Exchange Commission
(SEC)
A copy of filings we have made with the Securities and
Exchange Commission (SEC), including our 2002 annual filing
on Form 10-K, may be obtained through the web site of the
SEC (www.sec.gov), on our web site (www.novastaris.com) or
by contacting us directly.
Investor Relations
8140 Ward Parkway, Suite 300
Kansas City, Missouri 64114
816.237.7000
E-mail: [email protected]
80
4/22/03
6:21 PM
Page 5
OFFICERS
Ray Norris
John Pantalone
Sr. Vice President - Information Systems
Vice President - Conforming & Government Lending
Dave Pazgan
J. R. Samsing
Sr. Vice President - Wholesale East
Vice President - Retail Lending
Joseph Balch
Ronda Schrader
Regional Vice President
Vice President - Technical Servicing
Bradley Bur t
Brian Smith
Vice President - Information Technology
Adrian Cox
Emilio Soli
Vice President - Direct Channel
Allen Friedman
Ron Zaccaria
Vice President - Retail Lending
Scott Har tman
Chairman and CEO
Lance Anderson
President and COO
Mike Bamburg
Sr. Vice President - Portfolio
Wenhui Fang
Vice President - Portfolio Management
Dave Farris
Matt Kaltenrieder
Vice President - Securitization
Susan Johnson
NovaStar Home Mortgage, Inc.
Zhao Rong
Monica Price
Lance Anderson
President and CEO
Jon Roller
Scott Har tman
Executive Vice President
Joseph Sampson
Steve Landes
Sr. Vice President
John Schrader
Simone Dominique
Vice President - Branch Sales East
Jim Secrest
Stephen Haslam
Vice President - Branch Division
Theodore Venhorst
Michael Page
Vice President - Branch Operations
Joel Brenner
Brent Stuar t
Vice President - Operations Wholesale East
Vice President - Branch Sales West
Rodney Schwatken
Vice President - Controller
NovaStar Mortgage, Inc.
Lance Anderson
President and CEO
Scott Har tman
Executive Vice President
Jim Anderson
Sr. Vice President - Wholesale West
Mike Enos
Sr. Vice President - Marketing
Angela Gardiner
Sr. Vice President - Quality Control
Chris Casey
Vice President - Operations Correspondent Division
Scott Hebdon
Sr. Vice President & Chief Credit Officer
Chris Cornell
Vice President - Operations Wholesale West
Marian (Lainey) Hess
Sr. Vice President - Human Resources
Donna DelMonte
Vice President - Retail Operations
Steve Landes
Sr. Vice President - Retail
Beverly Dillingham
Vice President - Sales Support
Chris Miller
Sr. Vice President - Servicing
Scott Forst
Vice President - Collection
AmPro Financial Services, Inc.
Steve Landes
CEO
Mar y Jo Speier
President
Steven Parrish
Vice President
4/7/03
12:18 PM
•
Page 2
8140 Ward Parkway, Suite 300 • Kansas City, Missouri 64114
www.novastarIS.com • E-mail: [email protected]
•
816.237.7000

2002 Annual Report - Novation Companies

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